One of the traditional techniques for protecting assets, going
back literally hundreds years of Anglo-American jurisprudence,
trusts offer tremendous benefits when used appropriate circumstances
and often are underutilized for planning. Caution, however, that
certain transfers to trusts and types of trusts have been voided
by the state legislatures or by Congress in the bankruptcy code.
If you create a trust for your own benefit, you have established
a “self-settled trust”. If the trust instrument
contains provisions that prevent your creditors from reaching
your interest in trust assets, the trust is known as a “self-settled
spendthrift trust” (or, more commonly, an “asset
protection trust”).
For many hundreds of years, the provisions of self-settled
spendthrift trusts designed to protect trust assets from
creditors of the settlor/beneficiary were ineffective.
Beginning in the 1980’s, certain offshore jurisdictions
enacted specially-drafted trust laws overriding this long-standing
rule of trust law. Foreign asset protection trusts quickly
became popular. In 1999, the rush to form offshore trusts
slowed a bit after Michael & Denyse Anderson were jailed
for several months for their refusal (or inability, depending
on the side from which one views the case) to return funds
from their Cook Islands asset protection trust. Foreign
asset protection trusts became even less attractive the
following year when Stephen J. Lawrence was imprisoned
for his refusal to turn over assets from his Mauritius
asset protection trust. Lawrence was jailed in August,
2000, and remains jailed today.
In the late 1990s, Alaska led the charge of bringing self-settled
spendthrift trusts to the U.S., Delaware, Nevada and a
few other states soon adopted similar domestic asset protection
trust (DAPT) legislation hoping to attract trust business
to their states.
In the last few years, DAPTs appear to have overtaken
offshore trusts as the asset protection product du
jour, largely because of heavy marketing by trust
companies. The popularity of DAPTs is surprising because
their benefits are purely theoretical, There have been
no cases validating them., The laws of most states, including
those of the most populous states, prohibit self-settled
spendthrift trusts. Indeed, we and many others have predicted
that these trusts have little chance of working for debtors
in non-DAPT states.
The heavy marketing of DAPTs had the effect that marketing
usually has on asset protection strategies – it attracted
the attention of the press, and then, the attention of
legislators. Although many bankruptcy reform bills bounced
around the halls of Congress for several years none of
them contained provisions relating to asset protection
trusts. This year, however, while the Act was being debated
on the floor of the Senate, the New York Times ran an article
about DAPTs and how the rich would be able to protect vast
amounts of wealth in these trusts while decades-old bankruptcy
protections were stripped away from the poor.
The accuracy of the New York Times article was questionable
as the bankruptcy courts had in several previous cases
involving the foreign variant simply considered the trust
to be an agency arrangement instead of a bona fide trust,
thus including trust assets in the bankruptcy estate. Nonetheless,
just before passage of the Act, the Senate tacked on an
amendment offered by Missouri Senator Jim Talent which
may kill the DAPT business just as it was starting to gain
momentum.
Section 548 of the Bankruptcy Code relates to “Fraudulent
Transfers and Obligations”. Prior to the New York
Times article, the Senate had only slightly modified Section
548 by changing the limitations period from one year to
two years and some other minor changes. After the article,
the Talent Amendment adds a new subsection (e) to Section
548 as follows:
(e)(1) In addition to any transfer that the trustee
may otherwise avoid, the trustee may avoid any transfer
of an interest of the debtor in property that was made
on or within 10 years before the date of the filing of
the petition, if--
(A) such transfer was made to a self-settled trust
or similar device;
(B) such transfer was by the debtor;
(C) the debtor is a beneficiary of such trust or similar
device; and
(D) the debtor made such transfer with actual intent
to hinder, delay, or defraud any entity to which the
debtor was or became, on or after the date that such
transfer was made, indebted.
Since this provision deals what appears to be a fatal
blow to asset protection trusts, it is worthy of more detailed
discussion.
The 10-year period is measured from the date of the filing
of a bankruptcy petition, and there is no grandfather provision
for existing trusts. This is a very significant change
from previous law, since the ordinary bankruptcy limitations
period was only one year (increased to two years by the
new Act), and most states have four-year limitations periods
for challenging fraudulent transfers.
Next, this 10-year limitations period only applies to
self-settled trusts “or similar devices”. The
term “self-settled trust” is easy: It is a
trust that you create for your own benefit. Asset protection
trusts are typically self-settled trusts, as are living
trusts.
But what about “similar devices”? Could a
bankruptcy trustee use the new Section 548(e) to set aside
transfers to trusts that are settled by the debtor, in
which the debtor has a limited interest, such as a charitable
remainder trust or a qualified personal residence trust?
If a transfer to a charitable remainder trust were set
aside, the (non-dischargeable) tax consequences to the
debtor could be disastrous. Depending on the circumstances,
the original deduction could be disallowed, and interest
and penalties could apply retroactively.
Another concern of “or similar device” goes
to certain types of insurance products, such as “Swiss
Annuity” type products and variable universal life
insurance products that give their purchasers some investment
control, access to cash value, and have only the minimum
amount of pure life insurance necessary to satisfy IRS
requirements. A sophisticated creditor might make a convincing
argument that these arrangements are in the nature of self-settled
trusts and are colored with insurance only for technical
tax purposes, and thus are within the “or similar
device” orbit. With the overt marketing of some financial
products, such as private placement life insurance, as
asset protection tools, it is not difficult to imagine
a court accepting an interpretation of Section 548 by a
creditor or trustee to set aside transfers involving some
of these types of products.
We are not concerned with ordinary life insurance and
annuity products falling into the “or similar device” trap,
where they clearly are insurance contracts governed by
state insurance codes whose issuers are regulated by state
insurance commissioners,. However, our musings here illustrate
the vagueness of the “or similar device” language
of Section 548(e) and the potential for its interpretation
to encompass many asset protection strategies. It may be
some time before we have sufficient case law to be able
to say with any certainty that particular strategies fall
into or avoid that trap.
It is clear that that the language of Section 548(e) protects
future creditors, not just creditors existing at the time
of the transfer. Section 548(e)(1)(D) refers to to existing
creditors and to those who became creditors “on or
after the date that such transfer was made.” Congress
clearly intended that Section 548(e) apply for the benefit
of creditors who appeared only after the transfer occurred.
Nonetheless, many promoters falsely proclaim that there
is no fraudulent transfer risk if there are no current
creditors’ claims.
While the fact that a person has no claims against him
at the time of a transfer certainly is favorable, it is
not dispositive. Indeed, the same language referring to
future creditors appears in (unchanged) Section 548(a)(1).
Similar provisions appear in the Uniform Fraudulent Transfer
Act, which expressly protects future creditors in many
circumstances.
There have been some suggestions that the “actual
intent” language means that a transfer to a self-settled
trust can only be set aside if the debtor confesses that
he intended to defraud creditors. Of course, no sober debtor
would make such an admission if significant wealth was
at risk. Thus, Congress used the exact same phrase that
appears in Section 4(a)(1) of the Uniform Fraudulent Transfer
Act: “actual intent to hinder, delay, or defraud.” The
same phrase appears in Section 548(a)(1)(A) and is part
of the principal fraudulent transfer provision of the Bankruptcy
Code, that was unchanged by the new Act.
Under both the UFTA and Section 548(a)(1)(A), it is clear
that “actual intent” does not require a confession
by the debtor. To the contrary, “actual intent” long
has been proved by circumstantial evidence consisting of
certain factors (the “Badges of Fraud”) that
would indicate the debtor’s fraudulent intent. So
even if a debtor professes innocence and points to substantial
non-asset protection reasons for making transfers, the
court may still find that the debtor had the “actual
intent to hinder, delay, or defraud” if the circumstances
tend to indicate that to the judge.
There is also a new subsection (e)(2) that makes it clear
that subsection (e)(1) also applies to transfers in anticipation
of a judgment or fine, etc., arising from a violation of
state or federal securities laws, or “fraud, deceit,
or manipulation in a fiduciary capacity or in connection
with the purchase or sale of any security”. Some
have misread subsection (e)(2) to infer that the new 10-year
limitations period for self-settled trusts applies only
to securities fraud or breach of fiduciary duty, etc.,
but the “includes” language of (e)(2) is purely
supplementary and not limiting.
It is important to keep in mind that the bankruptcy courts
were in the habit of considering self-settled trusts to
be in the nature of agency relationships, and thus were
including self-settled trust assets in the bankruptcy estate
anyway. There is no 10-year statute of limitation for this,
so even those with “old and cold” asset protection
trusts may be sadly disappointed in bankruptcy if their
overall arrangement gives (direct or, as is the norm, indirect)
control over the distribution of trust assets to the settlor/beneficiary.
If settlors of old and cold APTs clearly do not have control
over the distribution of trust assets to themselves, the
assets of such trusts would not be included in their bankruptcy
estates. However, this presupposes at least two things:
first, that there are APT settlors who truly have no direct
or indirect ability to compel a trustee to make distributions
to them; and second, that a bankruptcy trustee and/or judge
would resist a likely urge to disregard the trust as an
agency relationship in any event.
The effect of new Section 548(e) is that if asset protection
trusts were not dead before, they should not now be used
as anything like an ordinary asset protection technique.
In more circumstances than not, it may now be the precipice
of malpractice to recommend an asset protection trust to
a client. The rare exception will be for those who establish
foreign asset protection trusts and who are willing and
able to flee the U.S. before the court enters the inevitable
repatriation order.
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