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The case for reform

Protected trust deeds and sequestration

3.1 There are significant differences between protected trust deeds and sequestration, although both should be seen as forms of bankruptcy. They both serve two key public needs:

• Debt relief for 'can't pay' debtors; and
• A fair division of available property by payment of dividend to creditors by a regulated trustee.

3.2 In protected trust deeds under current law:

• The trust can last for any period (although three years is typical);
• Debtors choose to use debt relief, that is they can't be forced into a trust deed;
• Debtors go to the IP of their choice;
• Debtors are not always seen as bankrupt;
• Creditors can block protection;
• Debtors can use credit ⁵;
• Debtors can carry on business;
• There are no criminal penalties;
• The only 'penalty' for failure to co-operate is to be sequestrated;
• Creditors receive little information;
• There is no compulsory audit of the trust accounts;
• There is no effective regulation of the conduct of the trustee, other than the requirement that the trustee is a member of a professional body;
• Creditors are on average paid more.

3.3 In sequestrations under current law ⁶:

• The sequestration lasts three years;
• Debtors can be forced into bankruptcy;
• Debtors rarely choose an IP to act as trustee ⁷;
• In nearly all cases the Accountant in Bankruptcy is the trustee;
• Debtors are restricted from using credit;
• Debtors are restricted from carrying on business;
• Debtors are barred from various offices, such as being a member of parliament;
• There are criminal penalties for breaching restrictions, or for failing to co-operate;
• There may be an audit of the sequestration accounts, which in all cases are available for inspection;
• There is effective regulation of the conduct of the trustee (who in most cases is the Accountant in Bankruptcy);
• Creditors are on average paid less.

3.4 The Executive considers that the main advantage of protected trust deeds for debtors (and by extension for trustees) is that it is less invasive of privacy, that there are few penalties for non-compliance, and that there is little or no regulation of the conduct of the trust.

3.5 The Executive considers that the main advantages of sequestration are that the public interest is better served by a high level of public protection through restrictions and penalties, and through the more detailed regulation of the conduct of the sequestration. This means that there is a remedy if (say) a bankrupt debtor sets up in business and fails to trade properly.

3.6 Protected trust deeds can therefore be seen as a 'softer' form of bankruptcy, although any form of bankruptcy is unpleasant and intrusive for the debtor. This is not a concern as such, and indeed other legal systems offer debtors some kind of choice. In England and Wales, for example, a similar choice to that in Scotland exists between formal bankruptcy and an individual voluntary arrangement (usually called an " IVA").

3.7 The Executive considers therefore that two forms of debt relief are justified if the benefit for the debtor is balanced by a benefit for the creditors. The creditors' main interest is in payment, and indeed the key difference between sequestration and protected trust deeds is that (in theory at least) a trust deed is only protected where creditors do not object.

3.8 Table 8 therefore shows the average dividend in pence in the pound of debt paid to creditors in sequestrations and protected trust deeds respectively in the period 2000 to 2005.

Table 8

3.9 It will be seen that on average trust deeds offer a better return to creditors than bankruptcy. However, the distribution of returns across all trust deeds presents a rather different picture. This point is considered below.

Integrated system of debt management and debt relief

3.10 The background to this consultation is a review by the Executive of formal debt management and debt relief tools for multiple debts. There are three such tools in Scotland:

• The Debt Arrangement Scheme (" DAS");
• Protected trust deeds; and
• Sequestration.

DAS is a debt management tool, and protected trust deeds and sequestration are debt relief tools.

3.11 Debt management offers more time to pay debts in full, and debt relief offers cancellation of debts that can't be paid at all. Any system of debt management and relief should:

• Treat debtors and creditors fairly;
• Be easy to use and to understand; and
• Offer a range of tools fit for different circumstances.

3.12 The Executive has considered the extent to which there is any undue overlap among the three tools above. In a properly integrated system there should be no overlap unless it serves a clear purpose, as in general having two tools doing more or less the same thing will make the system both harder to understand and less likely to be fair to either debtors or creditors.

3.13 The Executive has therefore taken 4 factors into account:

• Debtor protection;
• Debt relief;
• Payments from income; and
• Payments to creditors.

Debtor protection

3.14 All formal systems offer similar legal protections from further enforcement by creditors. There is a clear need for this, and therefore an equally clear justification for the overlap between the three tools.

Debt relief

3.15 DAS is intended to be a debt management tool, making it possible for those who could pay their debts in full to do so by making payments over a longer period. The debtor benefits through financial rehabilitation, balanced by a better understanding of money management gained through self discipline and money advice support.

3.16 DAS does not currently offer debt relief. The Executive is undertaking a separate review of DAS, and is considering whether some form of debt relief should be included as an option. It is arguable that the system lacks a modest form of debt relief falling between DAS and bankruptcy. For example, waiver of interest or charges after sustaining a debt payment programme for a suitable period.

3.17 DAS as at present is clearly different from any form of debt relief. If extended to enable some form of debt relief it will remain different from other available forms of debt relief.

3.18 Protected trust deeds and sequestration are both forms of bankruptcy ⁸. They both offer debt relief for those who can't pay their debts. At present all outstanding debts ⁹ can be cancelled using either tool.

3.19 There is an obvious need for sequestration as the debt relief tool of last resort. It is and should be a severe option for the debtor, as that justifies a small or no payment to the creditors.

3.20 A protected trust deed can have severe consequences for debtors, but it clearly has a less severe impact than sequestration. The Executive is however satisfied that a less severe form of debt relief is justified, provided that the other benefits of such a tool offer an appropriate balance.

3.21 The Executive considers therefore that protected trust deeds should be retained despite the overlap with debt relief in sequestration (and possible overlap with debt relief in DAS), subject to the right balance being struck between the interests of debtors, creditors and the public.

Payments from income

3.22 In all formal debt management and debt relief tools the debtor should expect to pay part of their income towards their debts, if they can afford to do so. 'Can pay, should pay' is an aspect of the Scottish system which is perhaps not well understood by debtors.

3.23 In DAS, the payment is voluntary. The debtor decides with the help of a money adviser how much they can afford to pay towards their debts. This surplus income is divided equally amongst the creditors in a debt payment programme. The creditors either agree to accept reduced payments over a longer period, or where they do not agree the DAS administrator or sheriff may approve the offer as 'fair and reasonable' ¹⁰.

3.24 In a protected trust deed there is no formal calculation of surplus income. The debtor and the trustee negotiate on whether or not the offer to creditors is funded wholly or partly from the debtor's income. The creditors' formal role is to reject the trust deed, although in practice creditors rarely express a view. There is no public oversight.

3.25 In a sequestration a request by the trustee (in most cases the Accountant in Bankruptcy) for a contribution from any surplus income has teeth. If refused the trustee can apply to the sheriff for a payment order. This aspect of sequestration is being reformed in the Bill, and made more effective. The Executive expects that more debtors with surplus income will be making payments from income in future.

3.26 There is therefore an overlap between all three tools, but 'can pay, should pay' is clear justification for this. However, protected trust deeds contrast with DAS and sequestrations in that there is no public oversight of the calculation of income payments. The Executive considers that this cannot be justified.

Payments to creditors

3.27 In DAS the creditors are paid in full. The absence of debt relief is compensated for by the low credit impact of debt management.

3.28 The advantage of a DAS debt payment programme for debtors is that they avoid the consequences of using debt relief such as loss of assets (including their home), criminal sanctions, and significant problems in getting affordable credit in the future.

3.29 As stated above, sequestration and protected trust deeds are both forms of bankruptcy. In both the creditors are paid a percentage of what they are due (a dividend), and the debtor is relieved from paying the balance of the debts otherwise due. There is no minimum required dividend in either case.

3.30 In a sequestration, a debtor is by law discharged from all outstanding debts and liabilities due at the date of the sequestration.

3.31 In a protected trust deed, the timing of the discharge depends on the terms of the deed. A creditor who is notified of the trust deed and does not object to it is said to have acceded to it. In most cases the debtor is discharged from the outstanding debt due to or liability in respect of a particular creditor on the accession of that creditor. In other cases the trust deed delegates the power of discharging debts to the trustee.

3.32 Table 8 shows that as the numbers of protected trust deeds have increased the average level of returns to creditors have reduced. The overlap in the level of payments to creditors in a sequestration and in a protected trust deed has increased. That overlap raises the issue of whether the reduced level of public protection in a trust deed is justified by:

• The extent to which there is a difference between the payments to creditors under the two tools; and
• The increase in the overlap in those payments.

3.33 The Executive therefore considered the issue of creditor payments in more detail.

3.34 The Executive does not currently keep statistics on protected trust deeds. The Accountant in Bankruptcy does however receive:

• A copy of the trust deed;
• Documents relating to the trust deed, but only where an audit is requested; and
• A statement by the trustee showing how the estate was realised and paid.

In April 2005 the Accountant sampled 341 closed and 161 open cases from 2000, 2001 and 2005.

3.35 In that sample 23% of protected trust deeds paid no dividend to creditors. Table 9 shows the range of dividends for each pound of debt due paid in those cases that did result in a dividend for ordinary creditors.

Table 9 ¹¹ Protected Trust Deeds

3.36 In 50% of all the sampled cases (closed or open) the debtor has no assets, and therefore any payments to the creditors and all payments to the trustees were funded from the debtor's surplus income. They are what might be called 'income only' trusts. In nearly all such cases either no dividend was paid, or where a dividend was paid it was more often than not less than 10 pence in the pound.

3.37 The Accountant in Bankruptcy keeps statistics for sequestrations. In the period covered by table 8 (2000 to 2005) 23% of sequestrations paid no dividend to creditors. Table 10 shows the range of dividends for each pound of debt due paid in those cases that did result in a return for creditors.

Table 10 Sequestrations

3.38 In a substantial number of bankruptcy cases there is little or no benefit to the creditors, although in general the payments in sequestrations compare well to those under protected trust deeds. Low or no payments can be justified in sequestration as it is the debt relief tool of last resort, and triggers robust public protections.

3.39 The Executive considers that this cannot be justified in protected trust deeds, and as a debt relief tool the trust deed is not sufficiently different from sequestration. This defect can however be remedied by providing for a minimum dividend in protected trust deeds.

3.40 Money spent on administering the trust estate is in principle available to be paid to the creditors in an increased dividend. The Executive notes that on average half of all funds realised in trusts in the sample were used to pay the trustees fees and outlays. This is a further argument for reform.

3.41 Providing for a creditor threshold will make it harder for debtors to get debt relief through a protected trust deed. This can be justified on the grounds that the relative ease of getting debt relief in a protected trust deed has had an unacceptable cost for creditors and for the public in terms of lack of proper oversight.

3.42 Can't pay debtors with insufficient assets for a trust deed, and who need debt relief, will still be able to apply to sequestrate themselves. Those debtors who currently get debt relief through a protected trust deed but are in fact 'could pays' rather than 'can't pays' will be able to get any protection they need through DAS.

Previous consultations

3.43 In 1998 the Scottish Office were concerned about the rising use of protected trust deeds, and the low level of regulation of such deeds. They published a consultation paper setting out three main concerns:

• A limited power to audit meant a limited understanding of the effect of protected trust deeds;
• A number of deeds had benefit for the creditors, and seemed designed to help the debtor avoid sequestration;
• Debtors who were not able to pay their debts could arrange with the trustee to be sequestrated through a protected trust deed.

3.44 Responses to the 1998 consultation supported new controls over protected trust deeds, but no opportunity has arisen before now to act on the reform proposals. The Scottish Executive has, however, continued to receive complaints about (for example) misleading marketing and poor value for creditors.

3.45 In November 2003, the Scottish Executive consulted on proposals for the reform of protected trust deeds in ' Personal Bankruptcy Reform in Scotland: a modern approach'. The proposals in the 2003 consultation focused on increased transparency of administration, and increased powers for the Accountant in Bankruptcy to audit and monitor protected trust deeds. The consultation paper and responses can be read by following this link:

http://www.scotland.gov.uk/Topics/Justice/Civil/17868/13245 .

3.46 In particular, the 2003 consultation proposed to reform protected trust deeds so that:

• Debtors declare that a statement of their financial affairs is full and complete, with a possible criminal penalty for default;
• All deeds have a defined date of completion;
• The trustee proves that the deed has been intimated to the creditors;
• The trustee confirms in writing that creditors have not objected;
• The Accountant in Bankruptcy can refuse to register a deed which will not lead to a reasonable payment for the creditors;
• A deed is only protected on registration in the Register of Insolvencies;
• The trustee is under a duty to pay the creditors as soon as possible, and sequestrate the debtor if no payment is to be made;
• The Accountant in Bankruptcy can refuse to register a trustee's discharge from their duty to the creditors;
• A discharge is effective on registration in the Register of Insolvencies; and
• The Accountant in Bankruptcy has a general power to audit deeds.

3.47 The changes proposed in the 2003 consultation could mean that debtors sign trust deeds which do not become protected. It therefore asked:

• Do you agree with the proposed measures to improve transparency and monitoring of protected trust deeds?
• Do you have additional or alternative proposals i.e. a cooling off period after signing a trust deed?

3.48 There was very strong agreement to the first question. Over 80% of respondents to the 2003 consultation supported improvement in this area.

3.49 On the second question, only one third of respondents to the 2003 consultation thought that anything further should be done. There is no clear pattern of views, other than to say that in general, respondents who commented were against a general cooling off period. However, the Executive does not consider that the benefits of such a period have been fully considered.

3.50 The Executive considered whether or not to reform protected trust deeds in the Bankruptcy and Diligence etc. (Scotland) Bill. The responses to the 2003 consultation were therefore analysed in ' Modernising Bankruptcy and Diligence in Scotland: a draft Bill and consultation' ¹², published in July 2004. The 2004 consultation document and draft Bill can be read by following this link:

http://www.scotland.gov.uk/consultations/justice/cdbdb-00.asp .

3.51 In the 2004 consultation the Executive confirmed that protected trust deeds would be reformed as proposed in the 2003 consultation, but in regulations rather than in the Bill.

3.52 The Bill is intended to make only those changes that need to be made in primary legislation, namely:

• Section 18 of the Bill amends Schedule 5 to the 1985 Act to provide the enabling powers which will be used to make the intended regulations; and
• Section 21 of the Bill gives the Accountant in Bankruptcy:
• A general power to supervise trustees in protected trust deeds; and
• A specific power to audit the accounts of trustees, and fix fees and outlays.

3.53 The Bill and accompanying documents can be read by following this link:

http://www.scottish.parliament.uk/business/bills/billsInProgress/bankruptcy.htm .

Why should we keep protected trust deeds?

3.54 The Executive is satisfied that in principle protected trust deeds are a useful tool, and therefore have their place in a reformed and integrated system of debt management and debt relief.

3.55 For example, they are distinct from DAS in that they offer:

• A high level of debt relief;
• In most cases, an earlier completion date; and
• Involvement by highly trained and qualified insolvency practitioners.

3.56 For example, they are distinct from sequestration in that they offer:

• A 'reward' for taking earlier action to resolve major debt problems;
• A less public, and therefore more dignified, solution to such problems; and
• A less intrusive debt regime, with (for example) no criminal penalties for failing to co-operate with the trustee.

Why should we reform protected trust deeds?

3.57 There have been consistent concerns about the way in which protected trust deeds are used since at least 1998. The strength of these concerns is demonstrated by the regular complaints made to the Executive, and the strong welcome given to the proposals for reform set out in the 2003 consultation.

3.58 As a result, the Executive is not satisfied the advantages of protected trust deeds are enough to outweigh the significant disadvantages. Reform is needed if they are to continue to be a useful tool.

3.59 When reformed, the need to pay the creditors more in a protected trust deed than in a sequestration will both encourage and reward debtors who tackle problem debt at an earlier stage. A protected trust deed will then strike the right balance. It will have a clear advantage over sequestration for both the creditors and the debtor.

Why consult again?

3.60 The regulations proposed in the 2004 consultation have now been drafted. The Executive is committed to reforming protected trust deeds, and therefore seeks views on the effectiveness of the draft regulations.

3.61 Policy as set out in the 2003 consultation has been developed and refined during the drafting process. Some further issues have arisen on which policy is not final, and therefore the Executive welcomes further comments on those issues.

3.62 The next two sections of this consultation paper look in more detail at what the draft regulations do, and set out the issues still to be decided on which views are sought. Section 4 considers the requirements of and threshold for protection, and section 5 considers issues around audit and oversight.

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