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.
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