Public Policy Interests of Domestic Asset Protection Trusts

Public Policy Interests of Domestic Asset Protection Trusts

These vehicles can offer benefits without violating creditors’ rights

Self-settled discretionary spendthrift trusts, also called domestic asset protection trusts (DAPTs), are irrevocable trusts in which the settlor is des- ignated a discretionary beneficiary. In general, DAPT structures offer settlors emergency access to trust assets, while making it more difficult for certain creditors to seize the assets. Other benefits include ensuring privacy, possible tax savings, flexibility to modify the trust if fam- ily circumstances change and the avoidance of intrafam- ily quarrels. Importantly, residents of states that haven’t enacted DAPT legislation may also take advantage of the potential benefits of DAPTs by designating, as the trust’s governing law, the law of a state that recognizes DAPTs. To help ensure that such law is respected, the settlor must take a variety of structuring and statutory steps, including choosing a trustee that’s located in the governing law state.

In spite of these benefits, it would assault our collective sense of fairness if an individual were able to take on a legitimate debt and then, by the contriv- ance of shoveling his assets into an irrevocable trust, avoid repaying that debt. And, we would be equally offended if another individual, contemplating a risky business endeavor, could make his assets unavailable to the enterprise by transferring them into a trust. Fortunately, our moral antennae needn’t be on con- stant alert, as these types of abuses are well covered by both state and federal fraudulent transfer laws, which uniformly give creditors the right to void such trans- fers. In contrast, DAPTs are concerned with future creditors and unanticipated events. The logic behind this critical distinction was stated clearly by the U.S. Supreme Court in Schreyer v. Scott: “[the settlor] had done no more than any businessman has a right to do, to provide against future misfortune when he is abundantly able to do so.”1

Nonetheless, there’s been a troubling pattern in some of the DAPT cases that have gone to court. Faced with financial stress, some planners and their clients have launched desperation DAPTs, usually involving a fraud- ulent transfer. Troubled by the specter of abuse, some courts and legislatures have searched for ways to render equitable relief.2 In fairness, these cases are in court for the very reason they’re troubling, but a more powerful analytic is at work. In practice, different creditors’ claims raise different sorts of policy concerns. In a complex commercial environment, a “one size fits all” rule may not be practical or desirable. In his thoughtful article on the subject, law professor Dr. Adam J. Hirsch considered the competing arguments and concluded “that the fun- damental principles of asset protection doctrine are, in point of fact, compatible with public policy.”3

A More Reasoned Perspective

Until the creation of the first DAPT in Alaska in 1997,4 the absolute transfer prohibition of the self-settled trust rule represented the state of U.S. law. But, as soci- ety became increasingly litigious and the effectiveness of some long-standing asset protection techniques was called into question,5 it was inevitable that planners and their clients would look to DAPTs as possible solutions. There are now 17 states that allow DAPTs,6 and new states seem to be added each year. Although the debate between DAPT supporters and self-settled rule proponents is ongoing, a look “under the hood” at the public policy issues surrounding DAPTs shows that these vehicles serve rather than harm the public interest.

Right to Asset Protection Planning

In their article, “Asset Protection Trust Planning,” estate-planning attorneys Duncan E. and Mark E. Osborne assess the critical environment for DAPTs:

While proclamations from the ivory tower have occasional value for the practitioner, it is far too easy for a legal purist peering down from high aloft to focus on a few instances of flagrant abuse …, stake out a position of moral outrage, and then universally condemn anyone who dares to engage in asset protection planning.[7] Although per- haps satisfying their sensibilities and finely-honed sense of moral rectitude … such a reaction is simplistic, unhelpful and unsupportable after even a cursory look at the asset planning abuse protec- tions already well-established in the law…

The benefits of DAPTs to settlors are real and substantial.

Almost all estate planning lawyers, almost all of the time, represent honorable, law abiding clients, men and women who daily contribute to society by their productivity and with their generosity, who pay their bills and their taxes, and who are not deadbeats, cheats, frauds, or criminals. These same good people, some of whom have acquired significant wealth by their own hard work or that of their forebears, are legitimately concerned about the excesses of an American litigation sys- tem which sometimes more resembles a lot- tery-like payoff game than it does a reliable forum for the settlement of genuine claims.

TOM HANKS SLAPPED WITH LAWSUIT OVER SON CHET’S CAR CRASH

Entertainment, The Wrap, Tim Kenneally, Mar 29th 2016 10:09 AM.

‘Chester Hanks was driving his vehicle in an unreasonable and unsafe manner and was under the influence of alcohol and/or drugs at the time his vehicle struck Mr. Moogan’s vehicle,’ the suit claims. According to the com- plaint, Tom Hanks and his wife, Rita Wilson, own the vehicle that Chet was driving. ‘Despite knowing that Chester Hanks was a careless and reckless driver they negligently handed him the keys,’ said Moogan.

Let’s be clear on this notion of duty. Even if some estate planning attorneys resist the idea, you can be assured the plaintiffs’ bar will not. The next wave of creative malpractice actions could well be against estate planning attorneys who fail to advise clients about asset protection alterna- tives, filed by clients who have suffered financial reverses which could have been avoided with such planning.8

Most Substantial Relationship

Typically, DAPTs are created in a state with enabling legislation, but the settlor is domiciled in a non-DAPT state. When courts are called on to determine the legal sustainability of a DAPT, a number of consider- ations will come into play, but the most important is whether the trust has its most substantial relationship to the trust state or the non-resident settlor’s state of domicile. A properly established DAPT will have all possible significant relationship factors tied to the trust state, so it stands to reason that the trust state’s laws should govern. For a practitioner, it’s essential to carefully establish and document the all-important relationship of the trust to the trust state, as the issues of jurisdiction, enforcement under the full faith and credit clause and choice of law may all turn on varia- tions of this singular point.

Not All Cases Involve Abuse

Each trust is different, and the same brush shouldn’t tar all cases. A properly used DAPT presents facts so dissimilar to instances of abuse, in both intent and fact, it demonstrates that individual cases can and should be distinguished and justice served to all par- ties. For example, critics of the DAPT like to point to In re Huber,9 a case in which the trust was breached, ignoring the damning case facts: (1) the debtor was threatened with litigation when the transfers occurred; (2) the transfers were of substantially all of the debtor’s assets; (3) the debtor retained control of the transferred property; (4) the transfer from the debtor to the trust was to an insider; and (5) the debtor was attempting to remove the assets from the reach of his creditors. The transfer was clearly fraudulent and void. But, as to the Huber court’s holding of relevant precedential interest (regarding choice of law), in spite of the bad facts, the court applied the law of the non-resident settlor’s state and held for the creditor but only because the settlor’s home state (not the trust state) had the most substantial relationship to the trust. This wouldn’t be the case with a properly established DAPT.

Non-Asset Protection Benefits

The benefits of DAPTs to settlors are real and substan- tial. For example, depending on the settlor’s needs and domiciliary state, there may be significant state tax savings and/or asset “freeze” opportunities. Further, you can draft a DAPT to provide for intra-family privacy, thereby avoiding generational quarrels. And, should the family’s circumstances change, there can be flexibility to modify the trust. The settlor’s potential opportunities are so significant that it seems fair to ask: “If DAPTs are sus- tainable in the face of legal challenge, do the attorneys of non-resident settlors have an obligation to discuss with their clients the pros and cons of designating a DAPT state as their trust jurisdiction?” The proper answer may be: “Why not, particularly if creditor protection is of no consequence to the settlor?”

Fraudulent Conveyance Protections

To what rights should pre-existing voluntary creditors be entitled? Should debtors be able to make risky loans and then render themselves judgment proof? The answer is no, but the question is a red herring. Fraudulent conveyance law affords the basic protections that every unsecured creditor presumably would insist on to make any loan agreement viable. And, under all of the existing domestic statutes, fraudulent conveyance law applies to the creation of a DAPT.

Further, protection for creditors from fraudulent conveyances has been strengthened by the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act,10 which acknowledges the legitimacy of DAPTs by: (1) deferring the authorization and regula- tion of such trusts to the individual states’ legislatures, and (2) specifically approving the right of bankruptcy estates to “claw back” assets fraudulently transferred into self-settled trusts.

Legislatures’ Motives

What are the legislative motives for enacting DAPT leg- islation? Typically, states are looking for trust business. As Dr. Hirsch admits:

The driving force behind these legislative initia- tives is clear enough. States are vying for trust business. We cannot, however, condemn these marketing statutes merely because their motives are impure … Policy developments and time may yet vindicate the vehicles they authorize … much as its close relative and doctrinal progenitor, the spendthrift trust, once did.11

Another keen example is the history of states compet- ing for industry by offering tax-exempt bonds and other monetary incentives to companies bringing employees into their states.

DAPTs Aren’t Deceptive

If DAPTs were deceptive, creating a false appearance of creditworthiness, creditor confidence would wane, and markets would suffer. Fortunately, no risk of deception arises, because there’s no appearance of the debtor con- tinuing to own any of the assets in the trust. Trustees must segregate and earmark the assets to distinguish them from the settlor’s assets. None of the leading trust state statutes depart from this fundamental trust prin- ciple. “Hence, DAPTs are not stealth vehicles, invisible to radar.”12 Their existence will be clear from a cursory review of a modern lender’s credit application, and a fail- ure to disclose will constitute a definitive badge of fraud under the fraudulent conveyance statutes, as well as run afoul of federal banking laws.

Involuntary Creditors

The most thought-provoking public policy issue facing the asset protection doctrine is presented by the follow- ing hypothetical scenario: A DAPT is created when the waters are calm for tax advantages, trust flexibility and to guard against unforeseen, but conceivable, involuntary creditors’ claims. Later, there’s a car accident. Certainly, the settlor can’t be accused of fraud because no claim or expectation of a claim had arisen when the trust was exe- cuted. Therefore, if a DAPT is properly established and otherwise sustainable, the trust should be a barrier to the claim.13 Should this prospect sound alarm bells?

Already, most states consider many techniques that provide some degree of creditor protection to be sound public policy. Examples include: individual retirement accounts, life insurance, annuities, homesteads, tenan- cies-by-the-entirety and Internal Revenue Code Sec- tion 529 plans. Some of these are already self-settled trusts. Should DAPTs be treated differently? Does the settlor’s potential to be protected encourage dangerous acts? It seems doubtful, as dangerous behavior also poses risks to the settlor and others. For professionals, their reputations, practices and incomes are strong incentives for occupational caution. Generally, public policy favors the free alienation of property. Is this a logical situation to restrict alienation? Clearly, these are philosophical questions about which honorable people can disagree, but the fundamental issue hasn’t changed since Schreyer14 resolved it in 1890. In short, how can the settlor be accused of fraud since no claim or expectation of a claim had arisen when the trust was executed?

DAPTs can offer protection or the opportunity for a fair settlement (of potential liabilities).

Creditors’ Rights

As cited in the Osborne article mentioned above,15 Professor Robert T. Danforth of Washington and Lee University School of Law published a balanced, provoc- ative and insightful article on creditors’ rights and trust law in the Hastings Law Journal. Prof. Danforth took aim at the lack of independent rationale and legal theory behind the rule against self-settled trusts, as espoused by Prof. Austin Wakeman Scott’s treatise and the Restatement (Second) of Trusts (for which Prof. Scott was the reporter and principal author):

Professor Danforth’s most provocative and sig- nificant conclusion stems from his examination of the tautological maxim of American law that one cannot create a self-settled spendthrift trust. Professor Danforth points out that … neither source offers a solid, independent rationale or theoretical basis for the rule. Moreover, and most interesting, the cases cited by Professor Scott do not, in fact, support the rule as he lays it out. As Professor Danforth gently remarks about these cases, it seems that ‘[Professor Scott] read them somewhat generously in support of his position.’

Professor Danforth further argues that the rule against self-settled spendthrift trusts, as espoused by Professor Scott, is not based on sound legal theory for a number of reasons. First, the rule ignores the rights of non-settlor beneficiaries, since the creditor can defeat the interests of those beneficiaries as well as the interests of the settlor. Second, it assumes a collusion between the settlor and the trustee, in which the trustee will blindly comply with the settlor’s bidding, ignoring the legal obligations of fiduciaries. Third, it grants creditors greater rights than the settlor, since the creditor can compel distributions and the settlor cannot. Finally, the rule fails to distinguish situations in which the creditor retains a power of dispo- sition from those in which the settlor does not.

Incongruous Results

Because the settlor no longer owns the DAPT assets, before the local court can issue a valid judgment, con- stitutional due process requires that the court obtain jurisdiction over the trust itself. The gravamen is that so long as the trustee doesn’t have substantive contacts with the settlor’s home state, there’s no local jurisdic- tion, and due process won’t be met.16 This precedent makes common sense because theories for local courts exercising expanded long-arm jurisdiction can meet with unexpected public policy results. Consider two scenarios proposed by Prof. Ralph U. Whitten:17 (1) If State X were to issue a license to carry a concealed weapon to someone in State X, all other states would have to allow the licensee to carry a concealed weapon within their borders, as a matter of full faith and credit. (2) Similarly, if State Y decided to issue driver’s licenses to 10-year olds, all other states also would have to allow State Y 10-year old license holders to drive within their borders as a matter of full faith and credit. Although these scenarios (at least the second) may seem extreme, it’s easy to imagine real world cases in which court pro- cedure and a particular court’s notion of public policy collide.

Reasons of Policy?

Dated model codes have withheld their approval of DAPTs or advanced the notion that they’re against public policy without explaining just how they’re against it. Essentially, the drafters who ingrained the rule in the Restatement of Trusts have left the sub- stantive defense of their stance to our imaginations.18 And, unless model lawmakers can spell out their rationales, how can actual lawmakers assess these rules?19 Consider a bank operating in a competitive credit environment. As a matter of policy, shouldn’t this voluntary creditor be free to reach any agreement it desires without interference from lawmakers and courts? “Those creditors who desire more protection can get it by demanding a security interest or addi- tional contractual restrictions on debtors’ behavior as a condition of the loan.”20 If the transfer to a DAPT downgrades a sound borrower into a poor credit risk, then the bank simply can deny the credit. Shouldn’t legal regulation be restricted to situations in which market imperfections create inefficiencies or in which market participants are prone to make systematic errors of judgment? Why should the legislature or the courts intervene to protect the more sophisticated party to the contract?

Trustee Enforcement

Restatement (Second) of Conflict of Laws Section 270 states this doctrine: An inter vivos trust in movables is valid if valid under the law of the state designated by the settlor to govern the validity of the trust, provided that the application of its law doesn’t violate a strong public policy of the state with which, as to the matter at issue, the trust has its most significant relationship (emphasis added).

The U.S. Supreme Court examined this “public policy exception” in Baker v. General Motors Corp. for public acts (for example, statutes).21 Baker is authority for the principle that a state won’t be forced to enforce another state’s public policy at the expense of its own public poli- cy. The court in Baker noted, “The Full Faith and Credit clause does not compel ‘a state to substitute the statutes of other states for its own statutes dealing with a subject matter concerning which it is competent to legislate’ (quoting Pac. Emp’rs Ins. Co. v. Indus. Accident Comm’n, 306 U.S. 493, 501 (1939)).”

In another context, an article by lawyer Elizabeth Redpath commented:

The idea that one state, by the imposition of con- trary public policy, can undercut the privileges conferred by another state is admittedly discom- forting, but it is the lesser of two evils. Without the public policy exception, full faith and credit could mandate outcomes that are unfathomable to the majority of Americans … In other words, although the public policy exception can delay the spread of popular public policy, it can also forestall the spread of unpopular public policy. More critically, if states are going to continue to serve as laboratories for new social and economic experiments, then every state—the ‘trial’ states and the ‘control’ states—must remain sovereign … Horizontal federalism is based on the assumption that separate sovereigns achieve great economic and social progress. And separate sovereigns are neither separate nor sovereign without the power to make and enforce their own domestic policies. The Full Faith and Credit Clause should fit within this context.22

Other Policy Support

There are other DAPT policy considerations, which, while important, are self-explanatory. These include:

  1. Much of the world already allows self-settled trusts;
  2. Trillions of dollars have/are moving to these jurisdictions;
  3. DAPTs create economic incentives and encourage entrepreneurship;
  4. DAPTs preserve U.S. business;
  5. DAPTs allow for U.S. oversight; and
  6. It’s illogical that outright gifts are allowed, but DAPTs aren’t.

Serving the Public Trust

In today’s world, doctors, lawyers, high risk pro- fessionals and high-net-worth individuals have just cause to be concerned about future liabilities. DAPTs can offer protection or the opportunity for a fair settlement. And, so long as the struc- ture is set up properly far in advance and with- out knowledge of a unique business risk or cred- itor problem, the public trust will be served.

Endnotes

  1. Schreyer v. Scott, 134 U.S. 405, 409 (1890)
  2. One approach has been to rely on the ancient and absolute transfer prohibi- tion of the self-settled trust rule (as distinguished from the fraudulent transfer rule), which entered the common law under the reign of Henry VIII’s father, Henry VII. Over the centuries, the self-settled trust rule found its way into our trust law, with states using differing methods to void transfers to a trust in which the settlor retains a beneficial interest.
  3. See Adam J. Hirsch, “Fear Not the Asset Protection Trust: I. Variations on a Theme,” Cardozo Law Review (January 2006), at p. 2686.
  4. See Alaska enabling statute Sections 34.40.010 to 34.40.13 (first U.S. state self-settled trust statute, post amendments).
  5. For example, in 2002, the U.S. Supreme Court held that a spouse’s interest in tenancy-by-the-entirety property was subject to a federal tax lien. See U.S. v. Craft, 122 S.Ct. 1414 (2002). In 2005, the bankruptcy law was changed, neg- atively affecting the treatment of retirement plans, homesteads, individual retirement accounts and domestic asset protection trusts (DAPTs).
  6. See Steven J. Oshins, “7th Annual Domestic Asset Protection Trust State Rank- ings Chart” (April 2016) (States by rank: Nevada, South Dakota, Tennessee, Ohio, Delaware, Missouri, Alaska, Wyoming, Rhode Island, New Hampshire, Hawaii, Utah, Virginia, Oklahoma, Mississippi, West Virginia). Colorado has limited ele- ments of a self-settled spendthrift trust (Colo. Rev. Stat. Section 38-10-111), but doesn’t meet ranking qualifications. Michigan enacted legislation in Fall 2016.
  7. What’s a limited liability company, after all?
  8. See Duncan E. Osborne and Mark E. Osborne, Asset Protection Trust Planning, The 
American Law Institute Continuing Legal Education with CLEW (June 2005).
  9. In re Huber, 201 B.R. 685 (Bankr. W.D. WA May 17, 2013).
  10. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Pub.L. 
109–8, 119 Stat. 23, enacted April 20, 2005, is a legislative act that made several 
significant changes to the U.S. Bankruptcy Code.
  11. See Hirsch, supra note 3, at pp. 2687-88.
  12. Ibid., at p. 2689.
  13. There’s yet no case law on point; therefore, the assertion is the author’s, based on legal and factual deduction. See Thomas E. Greene III, “Well-Craft- ed Self-Settled Trusts Formed by Nonresident Settlors Will Withstand Legal Challenge,” LISI Asset Protection Newsletter #328 (Aug. 17, 2016) and gener- ally, Richard W. Nenno and John E. Sullivan, “Domestic Asset Protection Trusts (Portfolio 868),” Tax Management Portfolio; David G. Shaftel and David H. Bun- dy, “Part I. Domestic Asset Protection Trusts Created by Nonresident Settlors,” Estate Planning (April 2005); and Hirsch, supra at note 3, p. 2690.
  14. Schreyer, supra note 1.
  15. See Osborne, supra note 8.
  16. See Hanson v. Denckla, 357 U.S. 235 (1958); Rose v. FirStar Bank, 819 A.2d 1247 (R.I. 2003); In the Matter of Estate of Ducey, 787 P.2d 749 (1990). See Restate- ment (Second) of Conflict of Laws Section 104 cmt. a. See Wilkes v. Phoenix Home Life Mut. Ins. Co., 902 A.2d 366, 382 (Pa. 2006); Estate of Waitzman, 507 So.2d 24, 25 (Miss. 1987); Underwriters Nat. Assurance Co. v. North Carolina Life & Accident & Health Ins. Guaranty Assn., 455 U.S. 691, 705 (1982).
  17. Ralph U. Whitten, “Full Faith and Credit for Dummies,” 38 Creighton L. Rev. (2005), at p. 477. See infra, Redpath, note 22.
  18. See Hirsch, supra note 3, at pp. 2697-98.
  19. Ibid., at p. 2698.
  20. Ibid., at p. 2688.
  21. Baker v. Gen. Motors Corp., 522 U. S. 222, 233 (1998). The case law distinguishes “public acts,” (for example, statutes) from monetary judgments to which the public policy exception doesn’t apply.
  22. See Elizabeth Redpath, “Between Judgment and Law: Full Faith and Credit, Public Policy and State Records,” Emory Law Journal (January 2013), at p. 639, discussing Adar v. Smith (Adar I), 597 F.3d 697, 701 (5th Cir. 2010), rev’d, 639 F.3d 146 (5th Cir. 2011) (en banc), cert. denied, 132 S.Ct. 400 (2011). Although Adar I involved the problems of a gay couple attempting to correct the birth certificate record of their adopted child after moving to a different state with a public policy opposing gay adoptions, policy consistency argues that the fun- damental full faith and credit principles are applicable.

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