Analysis of Domestic Asset Protection Trusts
a/k/a "Alaska Trust" or "Nevada Trust"
or "Delaware Trusts"

Domestic Asset Protection Trusts Neutered by Bankruptcy Reform

The 2005 changes to the Bankruptcy Code have created a new 10-year limitations period for transfers to self-settled trusts which are meant to hinder, delay or defraud creditors. This effectively means that all transfers to domestic asset protection trusts will be suspect for the 10 years prior to the date that a bankruptcy petition is filed. Because of this, domestic asset protection trusts should not be considered for asset protection planning and, indeed, in most circumstances it might be malpractice per se for an advisor to form a DAPT for his client if asset protection is a concern.

Introduction

The so-called Domestic Asset Protection Trust (DAPT) is a trust with a trust document that has basically the same anti-creditor features as an offshore trust, and is formed in one of the several states that have anti-creditor trust acts and now allow Self-Settled Spendthrift Trusts (i.e., trusts that allow you to establish a trust for yourself which protect you from creditors). Alaska was the first state to enact an anti-creditor trust act, followed quickly by Delaware, and then later by Nevada. A couple of other states have since enacted nearly identical legislation, but when you think of DAPTs you typically think of these three states. Thus, sometimes these trusts are called, almost interchangeably, “Alaska Trusts”, or “Delaware Trusts”, or “ Nevada Trusts”.

Cutting through the marketing whoopla, what you essentially end up with are state trust laws that allow the following:

• Self-Settled Spendthrift Trusts – These states allow you to form a trust for your own benefit that protects you against creditors, something expressly disallowed as against public policy of the other 40+ states.

• Shortened Statute of Limitations – There is a shortened time period for a creditor to challenge a transfer to one of these trusts.

• Conservative Fraudulent Transfer Standards – It is more difficult for a creditor to prove that a transfer to the trust was a fraudulent transfer.

The DAPT was created largely as a marketing tool to attempt to exploit the growing market for the Foreign Asset Protection Trust (“FAPT”). After the Anderson and Lawrence cases, the FAPT went out of vogue, and many planners are now advocating the use of DAPTs as a primary asset protection planning vehicle for clients. However, as with the FAPT before it, the benefits of the DAPT are largely theoretical, and as of this writing there have been no significant court cases validating the benefits of DAPTs in tough debtor-creditor situations. At the same time, the false hype of the FAPT promoters, who claimed that an Anderson- or Lawrence-type situation could “never occur”, are all too fresh in memory and similar claims are now being made by some DAPT promoters. Thus, it is a laudable goal to attempt to objectively evaluate how the DAPT might fare in certain scenarios, including scenarios that have already occurred with the very similar FAPT.

There are at least five glaring defects to the Domestic Asset Protection Trust that makes them, at best, a very weak asset protection method.

Glaring Defect #1: The trustee is subject to U.S. jurisdiction
If a U.S. court ordered an offshore trustee to do something, he could choose to simply ignore it since he is not bound by U.S. court decisions. However, a U.S. trustee can be compelled – by being thrown in jail for contempt – to do whatever the U.S. court wants. About as bad is the fact that the U.S. trustee is vulnerable to a civil lawsuit (trustee would rather give up your assets than his own), and also is available to law enforcement authorities that could bring money laundering charges, etc., to coerce the trustee to cooperate. This defect alone, of course, basically guts the alleged protection of the DAPT.

Glaring Defect #2: Full Faith and Credit
One of the best things about offshore trusts was that the offshore jurisdiction wouldn’t recognize a U.S. judgment, meaning that a creditor would have to start all over and begin the trial process from Day 1, bringing in witnesses, etc., from the U.S. or wherever, all of which is very expensive and time-consuming, and a is huge deterrent to creditors. Not so for a DAPT. No matter which state you form the trust in, that state is required by the “full faith and credit” clause of the U.S. Constitution to recognize the judgment of any other state. This means that a creditor only has to take its judgment and register the judgment without having to retry the case (a very simple process, done every day by collection firms), and Voila! the creditor is back at your throat.

Glaring Defect #3: Attempts to “import” law or to make a “choice of law”
in favor of the laws of Alaska, Delaware, or Nevada will probably fail
Think you can get an Oklahoma judge to apply Alaska law in favor of an Oklahoma resident against an Oklahoma judgment held by an Oklahoma creditor involving Oklahoma property? Ain’t happening – and if the trial judge rules against you then it is you (and not the creditor) who is fighting an uphill battle in a probably vain attempt to get the decision reversed on appeal, and in the meantime the creditor gets your assets and even if you win the appeal you might not get them back.

Glaring Defect #4: Federal Courts Will Ignore
Because of the Supremacy Clause of the U.S. Constitution, federal courts are not necessarily bound by state law, which is really ugly considering that the nightmare cases are about as often federal cases, or worse, defenses against federal administrative actions.

Glaring Defect #5: No chance of secrecy
Because the trustee is in the U.S., the trustee will be subject to discovery order and subpoenas, and as each states applies its own procedure (as opposed to substantive law) without regard to the other states' procedure, and the federal courts follow their own procedure, it means that any secrecy protections of the laws of the state where the trust is formed, will be totally irrelevant and ineffective.

Some Exemplary Scenarios

The scenarios that follow are based on the following hypothetical: The Settlor domiciled in a state that does not allow self-settled spendthrift trusts (“Non-State”) transfers assets from Non-State to a DAPT formed in DAPT-State. Later, Settlor is sued by civil Claimant in federal court sitting in Non-State. Claimant wins judgment against Settlor. Federal judge chooses Non-State fraudulent transfer law to set aside transfer as a fraudulent transfer, or the federal judge determines that the DAPT is void against the public policy of Non-State.

Typically, asset protection cases are hotly contested cases involving competent litigators for both the debtor and creditor. This is because the average controversy does not become an asset protection case. The average case is settled, often with the settlement being paid by an insurance carrier. By contrast, asset protection cases have not settled since they have gone on to judgment, and typically pit affluent individuals seeking to protect their wealthy against determined and often well-financed creditors (and sometimes governmental creditors).

Additionally, asset protection presumes that the creditor is “right” and that the equities are on the side of the creditor. If this weren’t the case, it was unlikely that the creditor would have obtained a judgment. Thus, the following scenarios anticipate that a judgment has been entered against the debtor by a judge who has come to believe that the judgment the judge has entered in favor of the creditor was warranted by the circumstances, and that the creditor should be paid on its judgment.

To more directly focus on the issues, it is presumed that the case is in federal court in a Non-State, and arises out from federal law, such as a claim arising under the Securities Act of 1933. Note, however, that many of the results below might still occur if the federal court was sitting in diversity, or if the suit were brought in state court for a claim arising under state law.

Scenario I

Direct FEDERAL COURT Order to Trustee

Relief Granted

Under the broad relief provisions of the Uniform Fraudulent Transfers Act adopted by Non-State, the federal judge enters an order compelling the DAPT Trustee to repatriate the assets to the Non-State.

Possible Effects

• The Trustee risks contempt by not repatriating the assets as ordered by the federal judge.

• If the Trustee repatriates the assets to the Non-State as required by the federal judge, the Claimant will be able to attach the assets.

Notes

This is a circumstance where an order entered by the courts of Non-State might not have the same power as an order issued by a federal court, since of course the state court’s power to enforce its orders stops at its borders (but see the Bank of Nova Scotia scenario below). The powers of the federal courts are, of course, nationwide and not reliant upon the Full Faith & Credit Clause.

Possible Authority

Federal Rule of Civil Procedure 64 (“At the commencement of and during the course of an action, all remedies providing for seizure of person or property for the purpose of securing satisfaction of the judgment ultimately to be entered in the action are available under the circumstances and in the manner provided by the law of the state in which the district court is held, existing at the time the remedy is sought . . ..”) (Emphasis added).

Scenario II

Anderson Scenario

The federal judge sitting in Non-State enters an order compelling Settlor to repatriate the assets from the DAPT-State to the Non-State.

Possible Effects

• If the Settlor refuses, the federal judge can order Settlor held in contempt for years.

• The Settlor might be held in contempt even if the Settlor has no ability to repatriate the assets to the Non-State.

Note

Those held in contempt in relation to FAPTs have consistently denied that they had any ability to repatriate the money from their foreign trusts, for example, but the judges involved have consistently ignored those claims.

A state court judge of Non-State could impose the same remedy.

Analogous Case

Federal Trade Commission v. Affordable Media, LLC, 179 F.3d 1228 (9th Cir. 1999) (affirming order incarcerating for six months settlors of Foreign Asset Protection Trust formed in the Cook Islands, with trust formed year prior to settlors’ bad conduct, who refused to repatriate trust assets to Nevada; settlors’ trust company later paid Federal Trade Commission settlement of $1 million to release trust company only from liability; Federal Trade Commission continues to pursuit settlors on underlying judgment) (this case is popularly known as the “Anderson case”, since the Andersons were the settlors who were incarcerated and the real parties in interest in this appeal).

Scenario III

Lawrence Scenario

The Settlor files for bankruptcy, or is forced into bankruptcy, in federal bankruptcy court sitting in the Non-DAPT State. The federal bankruptcy judge determines, under the laws of the Non-DAPT State, that the assets of the DAPT are part of the Settlor’s bankruptcy estate. The federal bankruptcy judge enters an order compelling the Settlor to repatriate the assets from the DAPT-State to the Non-State, and to turn the assets over to the federal bankruptcy trustee.

Possible Effects

• If the Settlor does not repatriate the assets, the Settlor may be held in contempt literally for years by the federal bankruptcy judge.

• The Settlor’s discharge may be denied.

• The Settlor may be charged with bankruptcy fraud.

• The Settlor, the Settlor’s Planners in both the Non-State and DAPT-State, and the Trustee, may be charged with conspiracy to commit bankruptcy fraud.

Analogous Case

Lawrence v. Goldberg, 279 F.3d 1294 (11th Cir. 2002) (affirming contempt order incarcerating debtor who had funded asset protection trust in Mauritius and then refused to list assets on bankruptcy schedule of assets or repatriate the assets to Florida; debtor originally incarcerated in 1999 and still incarcerated as of 2002; debtor’s discharge denied).

Scenario IV

Bank of Nova Scotia Scenario

The Trustee of the DAPT keeps the trust assets with Coast-to-Coast Brokerage Firm, which has a branch in Non-State (or any Non-State). The federal judge enters an order against the Coast-to-Coast branch in Non-State requiring Coast-to-Coast to turn over the trust assets to the Claimant.

Possible Effects

• Coast-to-Coast Brokerage Firm has to provide the assets to Claimant or face contempt and possibly significant fines.

Notes

This result would probably be the same if a court in Non-State ordered the local branch of Coast-to-Coast to turn over the trust assets to the Claimant.

Analogous Case

U.S. v. Bank of Nova Scotia, 740 F.2d 817 (11th Cir. 1984) (order of civil contempt fine of $25,000 per day and total fine of $1,825,000 affirmed against Miami branch of international bank that refused to disclose account records of Bahamas branch of bank to federal grand jury).

Scenario V

CIVIL CONSPIRACY Scenario

Claimant files a lawsuit for civil conspiracy under laws of Non-State against Settlor, and Settlor’s planners in Non-State, Settlor’s planners in DAPT-State, and against Trustee in Non-State. The federal judge finds that personal jurisdiction of DAPT-State Planner and Trustee is proper, insofar as the trust was intended to defeat the rights of creditors (whether known or unknown) in Non-State.

Possible Effects:

• Civil conspiracy is an intentional tort. If Claimant’s original action was dischargeable in bankruptcy, the effect is that the Settlor has converted a dischargeable action into one that is not dischargeable in bankruptcy.

• Settlor’s Non-State Planners, Settlor’s DAPT-State Planners, and the DAPT-State Trustee become personally liable for underlying judgment against Settlor.

• Settlor’s Non-State Planners and DAPT-State Planners might be subject to professional discipline for engaging in a civil conspiracy in violation of the laws of Non-State.

• The federal judgment for conspiracy against Trustee would be enforceable, despite the DAPT laws of the DAPT State.

Analogous Cases

Morganroth & Morganroth v. Norris, McLaughlin & Marcus, P.C., 331 F.3d 406 (3rd Cir. Appeal No. 02-2087, May 30, 2003). See also 1994 Land Fund II v. Ramur, Inc., No. 05-98-00074-CV (Tex.App. 5th Dist. 2001) (recognizing civil conspiracy theory arising from fraudulent transfer); A.T. Stephens Enterprises, Inc. v. Arnold Johns, 757 So.2d 416 (Ala. 2000) (judgment upheld for civil conspiracy to defraud creditors). Monastra v. Konica Business Machines, 43 Cal.App.4th 1628 (1996) (recognizing civil conspiracy action for defrauding creditors); Summers v. Hagen, 852 P.2d 1165 (Alaska, 1993) (in an action for conspiracy to fraudulently convey property, if the remedy of voiding the transfer is inadequate, the plaintiff is entitled to the lesser of the value of the property fraudulent transferred or the amount of the debt); McElhanon v. Hing, 728 P.2d 273 (Ariz. 1986) (a cause of action lies against a judgment debtor’s attorney who conspires with the debtor to defraud the creditor).

SUMMARY

Where DAPTs might work

As lame as the DAPT is as an asset protection tool, it probably has a fair-to-middlin’ chance of prevailing in the following circumstances:

• First, you actually live in Alaska, Delaware, Nevada or a state that has adopted a similar statute, have all of your assets there, fund the trust well in advance, keep the assets in either property in that state or in banks that have no branches in non-DAPT states, follow all formalities, and avoid federal court actions.

• Second, you actually live in Alaska, Delaware, Nevada or a state that has a adopted a similar statute, and you form a Foreign Asset Protection Trust (which, ironically, might stand up to some degree in these states since the Self-Settled Spendthrift Trust anti-public policy argument probably can’t be effectively asserted in these states), keep all the assets abroad, and you are willing to flee the country if things get too ugly.

Everybody else should do something else, because for you this probably isn’t going to work.

Conclusion

Conceptually, the mere existence of the DAPT is proof that there are serious questions about the FAPT. Many of the planners who used to crow about how “foolproof” the FAPT is (or, rather, was supposed to be), have now fallen off the offshore trust bandwagon in favor of domestic trusts. But don’t be fooled by the imitator: While the FAPT has actually been repeatedly blown up in the U.S. courts, and the DAPT hasn’t, the offshore trust is still a far superior asset protection method to its Domestic variant – since at least with an FAPT you can flee the country and your assets are already outside the U.S. Personally, I think that the DAPT is sort of a legalistic “bad joke”, unless of course you live in one of the states that allow these trusts, in which case it is simply a tool which, though anemic, is still probably better than nothing. Because of the potential flaws noted above, perhaps the term “Defective Asset Protection Trust” is a better name.

What this foreign/domestic vacillation really tells you is that the guys who make asset protection trusts a “centerpiece”, or any major piece of their asset protection plan, are totally confused by the failure of their former-champion, the FAPT, and now really don’t have much confidence in anything they are doing with trusts as an asset protection method. But as I stated at the outset of my discussion of trusts, in general trusts are fundamentally lousy asset protection vehicles, and they’d be better to abandon them entirely in favor of the numerous better methods that do work.

We frequently receive calls from folks who have been approached to "purchase" an offshore trust which, they are told, does not need to be reported to the IRS, and which trust will save them a bunch of income taxes. This is the purest B.S. -- there is simply NO WAY TO SAVE INCOME TAXES USING AN OFFSHORE TRUST, and anyone who tells you differently is probably lying. See, e.g., U.S. v. Kraig

This topic is now treated (in considerable depth) at http://www.quatloos.com/taxscams/contrusts.htm

Self-Settled Trusts After Bankruptcy Reform

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.

So ends our survey of what asset protection planning tools will not work under the new Bankruptcy Act. Now we’ll look at what still does work.