Castellano - 548(e) and Spendthrift Trust

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Castellano - 548(e) and Spendthrift Trust

Postby JDA » Sat Aug 09, 2014 9:27 am

In re Castellano, 2014 WL 3881338 (Bk.N.D.Ill., Aug. 6, 2014). http://goo.gl/4Ue5Dn

United States Bankruptcy Court, N.D. Illinois, Eastern Division.

In re Bruno and Linda K. CASTELLANO, Debtors.

Roy Safanda, Trustee in, Bankruptcy, Plaintiff,

v.

Linda K. Castellano and J.T. Del Alcazar, as Sucessor Trustee of the Faith F. Campbell Living Trust dated February 18, 1997, Defendants.

Bankruptcy No. 11 B 46854.Adversary No. 13 A 01257.

Signed Aug. 6, 2014.

Attorneys and Law Firms

Carl F. Safanda, Safanda Law Firm, Geneva, IL, for Plaintiff.

Aaron T. Troy, David F. Rolewick, Rolewick & Gutzke, Thomas A. Christensen, Huck Bouma, PC, Wheaton, IL, for Defendant.

Opinion



PROPOSED FINDINGS OF FACT AND CONCLUSIONS OF LAW

DONALD R. CASSLING, Bankruptcy Judge.

*1 On February 18, 1997, Faith F. Campbell ("Ms.Campbell") created the Faith F. Campbell Living Trust dated February 18, 1997 (the "Living Trust"). (Pl.Ex. No. 1.) The Living Trust provided that, upon her death, the assets in the Living Trust would be divided equally among her four children, one of whom is the Debtor in this proceeding. (Id. at sec. 9.01.) The Living Trust also contained a spendthrift clause (the "Spendthrift Provision") intended to shield the Living Trust's assets from seizure by her children's creditors. The wording of the Spendthrift Provision and its application to the Debtor in this proceeding are the focus of this Opinion. The Debtor claims that her one-quarter share of the Living Trust's assets is protected from her creditors by operation of the Spendthrift Provision. The Chapter 7 Trustee argues that the Debtor's share of the assets should be seized for the benefit of her creditors under a rarely-discussed section of the Bankruptcy Code, 11 U.S.C. sec. 548(e). Based upon the evidence introduced at trial and the Court's interpretation of sec. 548(e), the Court agrees with the Chapter 7 Trustee's position.

JURISDICTIONAL AND PROCEDURAL POSTURE OF THIS PROCEEDING

This matter is before the Court on a two-count complaint (the "Complaint") filed by Roy Safanda, the Chapter 7 Trustee (the "Chapter 7 Trustee"), against Linda K. Castellano (the "Debtor") and J.T. Del Alcazar, as successor trustee of the Living Trust (the "Spendthrift Trustee"). The Complaint seeks, first, to avoid alleged fraudulent transfers under 11 U.S.C. sec. 548(e) and, second, turnover of assets under 11 U.S.C. secs. 543 and 550. As discussed below, the Court finds in favor of the Chapter 7 Trustee under both counts of the Complaint.

The Court has jurisdiction over this proceeding under 28 U.S.C. sec. 1334 and Internal Operating Procedure 15(a) of the District Court for the Northern District of Illinois. Under the Supreme Court's recent ruling in Exec. Benefits Ins. Agency v. Arkison, No. 12–1200, 2014 WL 2560461 (U.S. June 9, 2014), the Court will treat the fraudulent conveyance count as if it were a noncore matter, even though 28 U.S.C. sec. 157(b)(2)(H) lists fraudulent conveyance actions as core proceedings. As authorized by the Supreme Court in Arkison, the Court will issue its Opinion in the form of proposed findings of fact and conclusions of law. To the extent a conclusion of law is improperly characterized as a finding of fact, it should be considered a conclusion of law. To the extent a finding of fact is improperly characterized as a conclusion of law, it should be considered a finding of fact. See In re Piper's Alley Co., 69 B.R. 382, 384 (N.D.Ill.1987).

FACTS AND BACKGROUND

Ms. Campbell died on February 11, 2011. As of October 31, 2011, the Living Trust held approximately $1.8 million in assets, not including the value of a cabin in Wisconsin. (See Pl.Ex. No. 6, Schedule of Assets Distributed.)

The Living Trust named the Debtor and her three siblings as equal beneficiaries and provided that "[u]pon the death of Faith F. Campbell and upon settlement of her estate, the Trustee shall divide and distribute as a class gift, free of Trust, the remaining [Living] Trust Estate." (Pl.Ex. No. 1, sec. 9.01.) Section 8.01 of the Living Trust further stated that, "[u]pon the death of Faith F. Campbell and upon settlement of her estate, this [Living] Trust shall terminate." The Living Trust was created in South Carolina, where Ms. Campbell resided. (Id. at sec. 8.01.)

*2 Upon the death of Ms. Campbell, Bank of America, N.A.1 was initially appointed as trustee of the Living Trust. Bank of America declined the appointment. (Pl.Ex. No. 2.) In March 2011, the Debtor and her siblings appointed the current Spendthrift Trustee as successor trustee. (Pl.Ex. No. 5.)

The Spendthrift Trustee is the husband of the Debtor's niece and is therefore related by marriage to all of the beneficiaries of the Living Trust, including the Debtor. No party claims that the Spendthrift Trustee is a disinterested party. No court appointed the Spendthrift Trustee to his position as successor trustee, no court supervises the exercise of his discretion under the Living Trust, and the Spendthrift Trustee has never been asked or required by any court or other agency to account for his handling of the Living Trust assets. (Pretrial Stmt., p. 15 at paras. 19–20.)

The Living Trust contains the following Spendthrift Provision in sec. 10.03:

If any beneficiary should attempt to alienate, encumber, or dispose of all or any part of the income or principal of this [Living] Trust before it has been delivered by the [Spendthrift] Trustee, or if by reason of bankruptcy or insolvency or any attempted execution, levy, attachment, or seizure of any assets remaining in the hands of the [Spendthrift] Trustee under claims of creditors or otherwise, all or any part of the income or principal might fail to be enjoyed by any beneficiary or might vest in or be enjoyed by some other person, then the interest of that beneficiary shall immediately terminate Thereafter, the [Spendthrift] Trustee shall pay to or for the benefit of that beneficiary only those amounts that the [Spendthrift] Trustee, in its sole and absolute discretion, deems advisable for the education and support of that beneficiary until the death of the beneficiary or the maximum period permissible under the South Carolina rule against perpetuities, whichever first occurs.

(Pl.Ex. No. 1) (emphasis added).

By letter dated October 5, 2011 (the "Insolvency Letter"), the Debtor's attorney informed the Spendthrift Trustee's counsel that the Debtor was insolvent and issued him the following mandate:

I am writing to you in relation to section 10.03 of the [Living] [T]trust [the Spendthrift Provision], to advise you that my client [the Debtor] and her husband have experienced insolvency due to the recession. They have closed their business and are filing for bankruptcy protection. [The Debtor] considers that it is the [Spendthrift] [T]rustee's obligation to exercise his authority consistent with the provisions of the [Living] [T]trust identified above [i.e., sec. 10.03].

(Pl.Ex. No. 9) (emphasis added).

At trial, the Spendthrift Trustee testified that after he received the Insolvency Letter, he opened up a separate Merrill Lynch account, named the "Faith F. Campbell Spendthrift Trust f/b/o Linda Castellano," into which he deposited the Debtor's one-quarter share of the Living Trust assets. (Pl.Ex. No. 6, Schedule of Assets Distributed) (emphasis added). Between themselves, the Spendthrift Trustee, and the Debtor referred to this account as the "Spendthrift Trust." Solely for the purpose of distinguishing this account from the Living Trust and without implying any legal consequences from the Court's use of any label, the Court will, in this Opinion, adopt the label "Spendthrift Trust" used by the parties themselves to describe this account.

*3 On November 21, 2011, the Debtor executed a "Receipt, Approval of Accounting, Release and Discharge of Trustee" (the "Receipt"). (Pl.Ex. No. 6.) In the Receipt, the Debtor averred that her status as a "named beneficiary" under the Living Trust was terminated as of October 5, 2011, by the Insolvency Letter. She characterized her current status as "a life-time, limited beneficiary at the sole discretion of the trustee of the Faith F. Campbell Spendthrift Trust created under the Campbell Living Trust (the 'Spendthrift Trust')."2 (Id.) (emphasis added).

In the Receipt, the Debtor states

I acknowledge that pursuant to the attached Schedule of Assets Distributed I will individually receive no distribution from the Living Trust and that the Spendthrift Trust shall receive my lifetime, limited beneficial interest. This is in full satisfaction of my rights and interests under the Living Trust, however reserving my beneficial interests pursuant to the Spendthrift Trust, I approve the Schedule of Assets Distributed.

(Id.) (emphasis added).

The Debtor filed her voluntary Chapter 7 bankruptcy petition on November 18, 2011 (the "Petition Date"). (Pre-trial Stmt., p. 15 at para. 10.) Paragraph 20 of Schedule B of her schedules3 lists the Debtor as the "[b]eneficiary of deceased mother's trust protected by spendthrift provision" in the amount of $400,000. (Bankr.No. 11 B 46854, Docket No. 1, Schedule B, para. 20.) However, the Living Trust itself is not listed as a creditor in the Debtor's bankruptcy Schedules, and the Spendthrift Trustee has not filed a proof of claim in the Debtor's bankruptcy case.

APPLICABLE STANDARDS

Section 548(e)(1) of the Bankruptcy Code permits a trustee to avoid, as a fraudulent conveyance, any transfer of assets made by a debtor into a "self-settled trust or similar device" within the ten years preceding a debtor's bankruptcy filing:

(e)(1) [T]he 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 the transfer was made, indebted.

11 U.S.C. sec. 548(e)(1) (emphasis added).

Section 548(e) has received little attention in the case law. However, there appears to be no dispute that Congress enacted sec. 548(e) in order to avoid the deleterious results of certain state laws4 that permitted debtors to shelter their assets from their creditors by placing them into self-settled spendthrift trusts (or similar devices) shortly before filing for bankruptcy. Quality Meat Prods., LLC. v. Porco, Inc. (In re Porco, Inc.), 447 B.R. 590, 595 (Bankr.S.D.Ill.2011); Alan N. Resnick & Henry J. Sommer, 5 Collier on Bankruptcy para. 548.07 at 548–87–89 (16th ed. rev.2014). By permitting the bankruptcy trustee to seize these assets for the benefit of creditors, sec. 548(e) restored the common-law rule allowing creditors to avoid pre-bankruptcy spendthrift trusts designed to shield assets from creditors of an insolvent debtor. Id. (citing H.R.Rep. No. 109–31, 109th Cong., 1st Sess. at 449–50 (2005)), reprinted in 2005 U.S.C.C.A.N. p. 88.

*4 The Chapter 7 Trustee bears the burden of proving, by a preponderance of the evidence, that the Debtor's actions constituted an avoidable fraudulent conveyance under sec. 548(e). See Helms v. Roti (In re Roti), 271 B.R. 281 (Bankr.N.D.Ill.2002), aff'd, No. 02 C 0925, 2003 WL 1089363 (N.D.Ill. Mar. 11, 2003); Thompson v. Jonovich (In re Food & Fibre Prot., Ltd.), 168 B.R. 408, 418 (Bankr.D.Ariz.1994) (citing Grogan v. Garner, 498 U.S. 279 (1991); W. Wire Works, Inc. v. Lawler (In re Lawler), 141 B.R. 425, 428 (B.A.P. 9th Cir.1992) ("A fair reading of the Supreme Court's opinion leads to the inference that the preponderance standard applies in all bankruptcy proceedings grounded in allegations of fraud.")).

DISCUSSION

Did the Debtor Transfer an Interest in Property?

The Debtor argues that she transferred nothing—she merely directed the Spendthrift Trustee to "exercise his authority consistent with the provisions of [Section 10.03, the Spendthrift Provision] of the [Living] Trust." According to the Debtor, any transfers or other dispositions of her share of the assets of the Living Trust were made by the Spendthrift Trustee in his complete and sole discretion, free from any exercise of control by her. The Chapter 7 Trustee argues, however, that the combined effect of the Insolvency Letter, the Receipt, and her familial relationship with the Spendthrift Trustee enabled the Debtor to effectuate a "transfer" of her share of the Living Trust assets. The Court agrees with the Chapter 7 Trustee's argument.

The Bankruptcy Code defines a "transfer" as "each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with—(i) property; or (ii) an interest in property." 11 U.S.C. sec. 101(54)(D) (emphasis added). The Court finds that the Debtor voluntarily effectuated an indirect, conditional parting with an interest in property-her share of the Living Trust assets. Rather than accepting direct receipt of those assets and then transferring them into a self-settled trust or the like, she recruited the Spendthrift Trustee to accomplish the equivalent result, schooling him, in the Insolvency Letter, in his "obligation to exercise his authority consistent with the provisions of the [Living Trust, i.e., sec. 10.03]." (Pl.Ex. No. 9.)

The Spendthrift Trustee honored her wishes by refraining from sending the Debtor her share of the Living Trust proceeds directly, instead setting up a new account (the Spendthrift Trust) into which he deposited the Debtor's share. The Debtor's use of the assets was then conditional, but only to the extent that it was subject to the discretion of an interested party, her nephew.

The Debtor confirmed both the fact and the effect of the transfer she had set in motion when she executed the Receipt. In that document, the Debtor confirmed in writing that the effect of the Insolvency Letter was to re-route her distribution from the Living Trust: "I acknowledge that ... I will individually receive no distribution from the Living Trust and that the Spendthrift Trust shall receive my life-time, limited beneficial interest." (Pl.Ex. No. 6.)

Were Assets Transferred into a Self–Settled Trust or Similar Device?

*5 A self-settled trust has been defined as "[a] trust in which the settlor is also the person who is to receive the benefits from the trust, usually set up in an attempt to protect the trust assets from creditors." Black's Law Dictionary 1746, 10th ed.2014. In determining the scope of the "similar device" language of the statute, the Court agrees with the court's conclusion in Porco that Congress's intent in enacting sec. 548(e) was to have the "similar device" provision interpreted broadly:

Collier on Bankruptcy notes that the congressional decision to leave undefined the terms used in sec. 548(e), such as "similar device," indicates an intent for courts to interpret the statute broadly so as to effectuate its aims, noting that, "even if crafty lawyers draft devices not technically "self-settled trust[s]," court[s] will have the power to scrutinize them under the "similar device" provision.

In re Porco, 447 B.R. at 595 (quoting 5 Collier on Bankruptcy para. 548.10[3] [a] (15th ed. rev.)); see also Battley v. Mortensen (In re Mortensen), Bankr.No. A09–00565–DMD, Adv. No. A09–90036–DMD, 2011 WL 5025249, at *6–7 (Bankr.D.Alaska May 26, 2011).

The Debtor argues that, because the Spendthrift Trust was created by the Spendthrift Trustee and is under his total discretion and control, the Spendthrift Trust was not in fact "self-settled" and therefore fails the test of sec. 548(e)(1)(A). The Court rejects this argument for the following reasons.

As discussed above, the Court finds that although the Debtor did not directly create the Spendthrift Trust, she caused its creation by advising the Spendthrift Trustee in the Insolvency Letter sent by her attorney that "Linda Castellano considers that it is the [Spendthrift] [T]rustee's obligation to exercise his authority consistent with the [spendthrift] provisions of the [Living] [T]rust ." (Pl.Ex. No. 9.) Thereafter, the Debtor confirmed in the Receipt that the effect of her coaching of the Spendthrift Trustee in the Insolvency Letter was to ensure that her share of the Living Trust assets would be distributed not to her individually but into the newly-created Spendthrift Trust. Read together, the Insolvency Letter and the Receipt provide strong evidence that the Spendthrift Trustee invoked the Spendthrift Provision and created the Spendthrift Trust in direct response to the Debtor's express wishes. By its own terms, the intent of the Spendthrift Provision is to shield a beneficiary's interest in the Living Trust from his or her creditors, and the Debtor is, by her own written admission in the Receipt, clearly a beneficiary of the Spendthrift Trust created thereunder. No evidence was introduced to suggest the contrary.

Further, the Court cannot ignore the family relationship between the Debtor and the Spendthrift Trustee, as well as the total absence of any court supervision or control over the Spendthrift Trustee's decisions concerning disposition of the assets of the Spendthrift Trust. Family ties militate against any trustee exercising completely unfettered, independent discretion in administering a spendthrift trust. Lack of judicial oversight exacerbates the risk that the Spendthrift Trustee's independent judgment will be compromised by family entanglements. The Debtor had reason to assume that despite the creation of the Spendthrift Trust she would have every opportunity to influence, if not simply instruct, the Spendthrift Trustee to disburse funds according to her own discretion. Whether the Spendthrift Trust was a self-settled trust or similar device, the practical effect is the same—the Debtor can justifiably expect to exercise a significant degree of control over its assets.

*6 Finally, sec. 548(e)(1)(A) provides an alternative to proof of the creation of a "self-settled trust"—proof of a "similar device" will suffice. In this case, the Court finds that the Chapter 7 Trustee has met his burden of proving that the Spendthrift Trust has each of the characteristics necessary to prove the creation of a device similar to a self-settled trust for purposes of analysis under sec. 548(e):

1. Like a self-settled trust, the Spendthrift Trust was created in part to shield the Debtor's assets from her creditors: The Spendthrift Trustee and the Debtor candidly admitted that the purpose of setting up the Spendthrift Trust was to shield assets from the Debtor's creditors. Indeed, the fact that the Spendthrift Trust was not created until after the Debtor had made a written declaration of insolvency and her written mandate to the Spendthrift Trustee "to exercise his authority consistent with the provisions of [the Spendthrift Provision] of the [Living Trust]" make it impossible to reach any other conclusion about the purpose of the parties in setting up the Spendthrift Trust.

2. Like a self-settled trust, the Spendthrift Trust was created to preserve the right of the Debtor to receive future distributions from the Living Trust: Both the Debtor and the Spendthrift Trustee also conceded that another important purpose of the Spendthrift Trust was to provide for the Debtor's education and support needs under sec. 10.03 of the Living Trust and that the Debtor's nephew, the Spendthrift Trustee, had complete and unfettered discretion to make sure that this occurred.

3. Although not directly created by the Debtor, the Debtor indirectly caused the creation of the Spendthrift Trust via the instructions she conveyed to the Spendthrift Trustee in the Insolvency Letter: While it is true that the Debtor did not personally set up the Spendthrift Trust, there is no dispute that the Spendthrift Trustee did so in response to her request that he "exercise his authority consistent with the [Spendthrift Provision]" of the Living Trust. The Court concludes that the Debtor satisfied the "self-settled" aspect of sec. 548(e) by using the Spendthrift Trustee as her cat's paw to create the Spendthrift Trust, rather than setting it up directly.

4. It is irrelevant for purposes of sec. 548(e) whether the formal requirements for establishing a trust under South Carolina law were satisfied: Finally, the Court finds that, under the "similar device" language of sec. 548(e), the Chapter 7 Trustee need not establish that a formal trust was established according to South Carolina law; an account that was directly or indirectly created by the Debtor to shield her assets from her creditors while retaining a right to receive the assets from that account suffices to meet the requirements of the statute. Any more restrictive interpretation than that would have the effect of reading the "or-similar-device" language out of sec. 548(e).

As a result of these obvious similarities between a self-settled trust and the Spendthrift Trust, the Court finds and concludes that the Spendthrift Trust was a device similar to a self-settled trust for purposes of sec. 548(e)(1)(A).

*7 The Court therefore finds that there was a transfer made by the Debtor to a self-settled trust or similar device under sec. 548(e)(1)(A) & (B).5

Was the Debtor a Beneficiary of the Spendthrift Trust?

The Debtor insists that she is not a beneficiary of the Spendthrift Trust under sec. 548(e)(1)(C). This assertion is contradicted by the evidence, including documents containing the Debtor's own characterization of her status. The Spendthrift Provision clearly contemplates that if the provision is invoked, the beneficiary of the Living Trust becomes a lifetime beneficiary of the resulting Spendthrift Trust. (Pl.Ex. No. 1.) Consistently with that reading, the Merrill Lynch account opened by the Spendthrift Trustee is titled the "Faith F. Campbell Spendthrift Trust f/b/o Linda Castellano." (emphasis added). The Debtor herself acknowledges the same when, in the Receipt, she describes herself as no longer a "named beneficiary" of the Living Trust, but now "a life-time, limited beneficiary at the sole discretion of the trustee of the Faith F. Campbell Spendthrift Trust created under the Campbell Living Trust." (Pl.Ex. No. 6) The Receipt further speaks of the Debtor's retention of her "beneficial interests pursuant to the Spendthrift Trust." (Id.)

Nor is the Debtor a "beneficiary" in name only. The instruments that designate her as such spell out the ways in which she substantively benefits from that status. The Spendthrift Provision provides that the Spendthrift Trustee "shall pay to or for the benefit of [a Living Trust beneficiary within the purview of the Spendthrift Provision] only those amounts that the [Spendthrift] Trustee ... deems advisable for the education and support of that beneficiary." The Spendthrift Trustee's interpretation of this provision is expansive.6 (Pl.Ex. No. 1, sec. 10.03.) At trial, he candidly admitted that, because he is not subject to any court oversight, it is within his sole discretion to distribute spendthrift funds for the Debtor's support and maintenance in any way he sees fit. By way of example, he could justify giving the entire amount in the Spendthrift Trust to the Debtor as a "support" distribution designed to alleviate the emotional anxiety she presumably feels as a result of her bankruptcy. This is not an entirely facetious analogy, given the family relationship between the two and the complete lack of court supervision over the Spendthrift Trustee's exercise of his discretion.

The Court finds that the Debtor is a beneficiary of the Spendthrift Trust for purposes of sec. 548(e)(1)(C).

Did the Debtor Transfer Assets with Actual Intent to Hinder, Delay or Defraud?

Finally, sec. 548(e)(1) requires the Chapter 7 Trustee to demonstrate that the Debtor acted with actual intent to hinder, delay, or defraud her creditors by making the transfer. See In re Sentinel Mgmt. Grp., Inc., 728 F.3d 660, 667–68 (7th Cir.2013) (discussing application of "actual intent to hinder, delay, or defraud" and stating that a defendant could have an actual intent to defraud without having an actual intent to cause harm). For the following reasons, the Court finds and concludes that the Chapter 7 Trustee has established that the Debtor had the requisite actual intent.

*8 First, the timing of the Debtor's execution of the Receipt, as well as the Spendthrift Trustee's creation of the Spendthrift Trust and distribution to the other three beneficiaries of the Living Trust, appear to have been dictated in large part by the Debtor's insolvency and bankruptcy petition. Under the terms of the Living Trust, its assets should have been distributed to the four beneficiaries upon or shortly after Ms. Campbell's death, which occurred on February 11, 2011, and upon settlement of her estate.7

As early as March 2011, the Spendthrift Trustee (according to his own testimony) became aware of the Debtor's financial difficulties. Although the Debtor's urgent need for cash was therefore apparent to the Spendthrift Trustee, he did not make the mandated distributions to the beneficiaries of the Living Trust in a timely manner. Not until October 5, 2011 did the Debtor issue the Insolvency Letter to the Spendthrift Trustee, who then invoked the Spendthrift Provision and created the Spendthrift Trust. The Spendthrift Trustee admitted that he did not make any distributions to any of the named beneficiaries of the Living Trust until after October 31, 2011. The Debtor executed the Receipt on November 21, 2011, and the Spendthrift Trustee deposited her distribution into the Merrill Lynch account opened for her benefit. (See Pl.Ex. No. 6.) The Debtor was therefore already insolvent on the date she executed the Receipt, as well as at the time the Spendthrift Trustee made distributions. Along with the Debtor's testimony that the purpose of the Spendthrift Trust was to prevent creditors from reaching her interest, the Court finds that these facts establish that the Debtor and the Spendthrift Trustee at a minimum contemplated using the Spendthrift Trust device as a mechanism to avoid the Debtor's creditors. Indeed, they suggest that the Debtor and the Spendthrift Trustee actively planned and structured the creation of the Spendthrift Trust with the explicit purpose of shielding those assets from creditors—the precise action that sec. 548(e) was created to avoid. Even now, the Spendthrift Trustee continues to maintain that account subject to his sole discretion to distribute funds for the Debtor's support or education.

In summary, the transfer of funds was not timed in accordance with the terms of the Living Trust or even with the onset of the Debtor's financial need. It was delayed until an instrumentality had been created to deny the Debtor's creditors access to these assets while making them available for the Debtor's benefit.

Second, the Debtor testified at trial that her understanding was that the Spendthrift Trust was created to prevent her creditors from reaching her one-quarter share of the assets. The Spendthrift Trustee was equally candid, testifying that the purpose in setting up the Spendthrift Trust was to shield assets from the Debtor's creditors. This testimony, coupled with the timing of the events outlined above, make it impossible to characterize the purpose of the parties in setting up the Spendthrift Trust as anything other than to thwart the Debtor's creditors. Therefore, the Court finds that the Debtor intended to hinder, delay, or defraud her creditors in making the transfer.

Turnover and Recovery of the Transfer Under 11 U.S.C. secs. 543 & 550

*9 Having found that the transfer of the Debtor's interest in the assets of the Living Trust and the Spendthrift Trust is avoidable by the Chapter 7 Trustee, the Court further finds that sec. 550 entitles the Chapter 7 Trustee to recover the value of the same.8 In addition, having concluded that the transfer is avoidable under sec. 548(e), the Court finds that the Chapter 7 Trustee is likewise entitled to enforce the avoidance of that transfer under sec. 543, as requested under Count II of the Complaint, because the Spendthrift Trustee is acting as a custodian, in control of property of the estate under sec. 543(a). The Spendthrift Trustee is therefore required by sec. 543(b)(1) to turn over the property of the Debtor in his possession and to file an accounting under sec. 543(b)(2). Therefore, the Court finds that the Chapter 7 Trustee is entitled to turnover of the property by the Spendthrift Trustee under sec. 543.

CONCLUSION

For the foregoing reasons, the Court recommends that the District Court find that the Chapter 7 Trustee has met his burden and has established an avoidable transfer under sec. 548(e)(1). The Court therefore recommends that the District Court find in favor of Roy Safanda, in his capacity as Chapter 7 trustee of the bankruptcy estate of Linda Castellano, and further find that the funds in the Spendthrift Trust shall be turned over to the Chapter 7 Trustee under secs. 543 and 550.

These constitute the Court's proposed findings of fact and conclusions of law in accordance with Federal Rule of Bankruptcy Procedure 9033.

Footnotes

1

Ms. Campbell named Merrill Lynch Trust Company of North Carolina as her original choice to be Trustee of her Living Trust, but by the time of her death, Bank of America had become the successor-in-interest to Merrill Lynch.

2

The Court notes this is the second time the parties used the term "Spendthrift Trust" to describe the Merrill Lynch account.

3

This paragraph requires the Debtor to list "[c]ontingent and noncontingent interests in estate of a decedent, death benefit plan, life insurance policy, or trust."

4

At the time sec. 548(e) was added to the Bankruptcy Code, five states (Alaska, Delaware, Nevada, Rhode Island, and Utah) had enacted statutes permitting debtors to shield their assets from creditors by transferring them to self-settled spendthrift trusts. Quality Meat Prods., LLC. v. Porco, Inc. (In re Porco, Inc.), 447 B.R. 590, 595 (Bankr.S.D.Ill.2011).

5

There is an alternative analysis which leads to the same result. It is undisputed that the Living Trust set up by Ms. Campbell was a "self-settled" trust, since it was directly created by Ms. Campbell. All that sec. 548(e) requires is that the avoidable transfer be made within ten years of the bankruptcy filing by a debtor beneficiary. Even if the Court were to ignore the Spendthrift Trust and look solely at the Living Trust, the Debtor's actions taken in the Insolvency Letter and the Receipt would still have accomplished a "transfer" into a "self-settled trust or similar device," i.e., the Living Trust created by Ms. Campbell, that would be avoidable under sec. 548(e).

6

For her part, the Debtor agreed at trial that the Spendthrift Trustee has complete and unfettered discretion at any time to distribute unlimited Spendthrift Trust funds for her support, maintenance, and/or education.

7

The Spendthrift Trust was not created until approximately six months after Ms. Campbell's death, even though the Living Trust language requires a distribution of the assets and termination of the Living Trust upon Ms. Campbell's death and settlement of her estate. While the Debtor argues that settlement of the estate could not have occurred until the sale of a Wisconsin cabin owned by Ms. Campbell, there was nothing preventing the Spendthrift Trustee from distributing the liquid assets of the Living Trust to the beneficiaries much earlier than that if he elected to do so. The Spendthrift Trustee's authority to make disbursements and distributions was established by his testimony that he made a number of disbursements shortly after Ms. Campbell's death without waiting for sale of the Wisconsin cabin. (See, e.g., Pl.Ex. No. 6, Schedule of Assets Distributed.)

8

Section 550 provides in part that to the extent a transfer is avoided under sec. 548, the Chapter 7 Trustee "may recover, for the benefit of the estate, the property transferred from ..., the initial transferee," in this case, the Spendthrift Trustee. 11 U.S .C. sec. 550(a)(1).
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Re: Castellano - 548(e) and Spendthrift Trust

Postby JDA » Thu Apr 30, 2015 8:58 am

Safanda v. Castellano, 2015 WL 1911130 (N.D.Ill., April 27, 2015).

United States District Court, N.D. Illinois, Eastern Division.

Roy Safanda, Trustee in Bankruptcy, Plaintiff,

v.

Linda K. Castellano, individually, and J.T. Del Alcazar, as Successor Trustee of the Faith F. Campbell Living Trust dated February 18, 1997, Defendants.

No. 14 CV 07094 | Signed April 27, 2015

MEMORANDUM OPINION AND ORDER

Manish S. Shah, United States District Judge

*1 Plaintiff Roy Safanda is the trustee appointed to administer the bankruptcy estate of debtor-defendant Linda Castellano. In this adversary proceeding, Safanda seeks the turnover of Castellano's share of her deceased mother's Living Trust, which is being held by defendant J.T. Del Alcazar as successor trustee. The bankruptcy court below agreed with Safanda's argument that Del Alcazar's current possession of the assets is avoidable under 11 U.S.C. sec. 548(e) and that the funds should be turned over to the bankruptcy estate. Defendants Castellano and Del Alcazar objected to these proposed findings of fact and conclusions of law.

For the following reasons, I find in favor of defendants and against Safanda.

I. Legal Standards

On these claims to avoid a fraudulent transfer under 11 U.S.C. sec. 548 and for turnover under 11 U.S.C. secs. 543 and 550, brought in-part against a non-party to the bankruptcy (Del Alcazar), a district court reviews the bankruptcy court's proposed findings of fact and conclusions of law de novo. See Stern v. Marshall, ––– U.S. ––––, 131 S.Ct. 2594, 2620 (2011); Executive Benefits Insurance Agency v. Arkison, ––– U.S. ––––, 134 S.Ct. 2165, 2173 (2014); see also In re Bellingham Insurance Agency, Inc., 702 F.3d 553, 561–65 (9th Cir.2012).

Courts dispute the appropriate evidentiary standard to apply to fraudulent-transfer claims. Some say a plaintiff must prove his claim by a preponderance of the evidence. See, e.g., In re McCook Metals, L.L.C., 319 B.R. 570, 587 n.11 (Bankr.N.D.Ill.2005). Others say he must do so with clear and convincing evidence. See, e.g., In re Art Unlimited, LLC, 356 B.R. 700, 707 (Bankr.E.D.Wis.2006). The Seventh Circuit has not recently weighed in on the matter, but in a fraudulent-transfer decision dating to the 1940s, it stated in dicta that "fraud ... must be proved by clear and convincing evidence." Springmann v. Gary State Bank, 124 F.2d 678, 681 (7th Cir.1941).

The Supreme Court more recently clarified in Grogan v. Garner, that "[b]ecause the preponderance-of-the-evidence standard results in a roughly equal allocation of the risk of error between litigants, we presume that this standard is applicable in civil actions between private litigants unless 'particularly important individual interests or rights are at stake.' " 498 U.S. 279, 286 (1991) (holding that a debtor's interest in discharging debts in bankruptcy is not a sufficiently important interest to warrant the heightened standard of proof).1

*2 In light of the presumption mandated by Grogan, and because a trustee-as-creditor's interest in avoiding a fraudulent transfer is not materially more important than the interest at stake in Grogan, the preponderance-of-the-evidence standard applies in this case.

II. Facts

The Faith F. Campbell Living Trust

On February 18, 1997, Faith F. Campbell created the Faith F. Campbell Living Trust. Campbell appointed herself as initial trustee and gave herself the unrestricted authority during her lifetime "to add or withdraw assets or property of the Trust Estate." [53–1]2 secs. 1.01, 3.01. The Living Trust named Campbell as the "Income Beneficiary" and her four children–including defendant Linda Castellano–as the "Beneficiaries." Id. secs. 6.01, 9.01(b)-(c), 13.04(f). In a section called "Spendthrift Provision," the Living Trust further instructed that (id. sec. 10.03):

[N]o beneficiary of the Trust shall have any right, power, or authority to alienate, encumber, assign, or pledge his or her interest in the principal or income of the Trust in any manner. No interest of any beneficiary shall be subject to any claims of his or her creditors (including the creditors of the spouse of a married beneficiary) or liable to attachment, execution, or other process of law.... [I]f by reason of bankruptcy or insolvency ... all or any part of the income or principal might fail to be enjoyed by any beneficiary or might vest in or be enjoyed by some other person, then the interest of that beneficiary shall immediately terminate. Thereafter, the Trustee shall pay to or for the benefit of that beneficiary only those amounts that the Trustee, in its sole and absolute discretion, deems advisable for the education and support of that beneficiary until the death of the beneficiary or the maximum period permissible under the South Carolina rule against perpetuities, whichever first occurs....

Campbell died February 11, 2011, survived by all four of her children. [53–5] at 1–2. The Living Trust originally named Merrill Lynch Trust Company of North Carolina as successor trustee, but that entity–having been absorbed by Bank of America–declined to take the job. Id. It therefore fell to the four beneficiaries to appoint a replacement, and together they chose defendant J.T. Del Alcazar–the husband of Castellano's niece. [50] at 62:15–34:8.

Castellano's Financial Problems

For 37 years, Castellano and her husband owned and operated a moving business called Peacock Relocation Services. [50] at 46:13–15. Peacock began experiencing financial difficulties in 2008 due to the recession, which eventually led to its closure in the summer of 2011. Id. at 46:9–24. By that following fall, Castellano and her husband decided that they needed to file for bankruptcy. Id. at 47:14–15.

On October 5, 2011, an attorney representing Castellano sent a letter to an attorney for Del Alcazar, stating ( [53–9] at 1):

I am writing to you in relation to section 10.03 of the trust [i.e., the "Spendthrift Provision"], to advise you that my client Linda Castellano and her husband have experienced insolvency due to the recession. They have closed their business and are filing for bankruptcy protection. Linda Castellano considers that it is the trustee's obligation to exercise his authority consistent with the provisions of the trust identified above.

*3 Upon receiving this letter, Del Alcazar "took it upon [him]self" to move approximately $400,000 (one-quarter of the Trust Estate) from the primary account at Merrill Lynch to a second account at the same institution. [50] at 96:8–12; 100:37; 101:13–103:16. Del Alcazar named the second, smaller account the "Faith F. Campbell Spendthrift Trust [for the benefit of] Linda Castellano." Id. at 101:21–25; [53–6] at 12. Although Del Alcazar characterized this second account as a "Spendthrift Trust"–which could suggest that it constituted a newly settled trust– the record evidence demonstrates that no new trust was created. Del Alcazar simply moved a portion of the Trust Estate from one account to another, as he was empowered to do by the terms of the Living Trust. See [53–1] sec. 4.02(b).

On November 18, 2011, Castellano and her husband filed voluntary Chapter 7 bankruptcy petitions. See In re Bruno and Linda K. Castellano, 11–BK–46854 (Bankr.N.D.Ill.). Three days later, Castellano signed a document entitled "Receipt, Approval of Accounting, Release and Discharge of Trustee." [53–6]. As the name suggests, the document acknowledged that Castellano had received an accounting from Del Alcazar, approved Del Alcazar's proposed distribution of the Trust Estate, and released Del Alcazar from any claims. Id. at 1–2. Castellano also agreed that (1) her interest in the Living Trust under sec. 9.01 was terminated pursuant to sec. 10.03; (2) she had become a "life-time, limited beneficiary at the sole discretion of the trustee" of the Living Trust; (3) her insolvency required the trustee to retain her interest pursuant to the "Spendthrift Provision"; and (4) she would receive no distribution from the Living Trust, but that the "Spendthrift Trust" (i.e., the second account at Merrill Lynch) would receive her "life-time, limited beneficial interest ... in full satisfaction of [her] rights and interests under the Living Trust, [but] reserving [her] beneficial interests pursuant to the Spendthrift Trust." Id. at 1.

In December 2011, Del Alcazar made distributions from the Trust Estate to Castellano's three siblings. [50] at 43:19–24; 61:24–62:3; 94:1–6. He never made a distribution to Castellano. Id.

Adversary Proceeding

On October 25, 2013, plaintiff Roy Safanda, the trustee appointed to administer Castellano's bankruptcy estate, instituted an adversary proceeding against Castellano and Del Alcazar. See Safanda v. Castellano, et al., 2013–A–01257 (Bankr.N.D.Ill.). Count I of Safanda's complaint seeks to avoid the transfer of the assets to the "Spendthrift Trust" under 11 U.S.C. sec. 548(e). Count II seeks turnover of those assets to Castellano's bankruptcy estate.

After a trial, the bankruptcy court entered Proposed Findings of Fact and Conclusions of Law, in which it recommended that judgment be entered in favor of Safanda on both counts. Castellano and Del Alcazar timely objected.

III. Analysis

A. Section 541(c)(2)

When a debtor files for bankruptcy, it automatically creates an estate containing "all legal or equitable interests of the debtor in property as of the commencement of the case." 11 U.S.C. sec. 541(a)(1). Section 541(c)(2) is an exception to this rule. Property of the debtor that would otherwise be transferable is not transferred to the bankruptcy estate if: (1) it consists of a beneficial interest in a trust, (2) the trust agreement contains language restricting the transfer of the interest, and (3) the transfer restriction is enforceable under "applicable nonbankruptcy law." See 11 U.S.C. sec. 541(c)(2).

The parties cited sec. 541(c)(2) in their Joint Pretrial Statement and, although not discussed in the bankruptcy court's recommendation, this section should be considered in this case. If a trust-interest is excluded from the bankruptcy estate under sec. 541(c)(2), the bankruptcy trustee has no basis to avoid its transfer. See, e.g., In re Hill, 342 B.R. 183, 206 (Bankr.D.N.J.2006) ("Even accepting the Trustee's theory that Phyllis transferred a 17% interest in Daniel's pension that should have been hers in equitable distribution, avoiding that transfer would not make any assets available for creditors."); see also Matter of McClellan, 99 F.3d 1420, 1423 (7th Cir.1996) ("Bankruptcy courts do not have subject matter jurisdiction and cannot administer property excluded from or outside the bankruptcy estate."). If sec. 541(c)(2) applies, then Safanda cannot pursue the transfer and turnover claims.3

Castellano's interest was in a trust

*4 Safanda indirectly argues that the day Castellano filed for bankruptcy, she had no interest in the Living Trust because it had already terminated. Section 8.01 of the Living Trust states that "[u]pon the death of Faith F. Campbell and upon settlement of her estate, this Trust shall terminate." The Living Trust does not define "estate," but Safanda believes it should be taken to mean "probate estate." Since no probate estate was opened here, Safanda believes the conditions of sec. 8.01 were satisfied the day Campbell passed away. If true, it would mean the trust terminated months before Castellano filed her petition, thereby precluding her from having an interest in the trust at filing. Defendants reject this interpretation. They think the word "estate" is better understood to mean "Trust Estate," which the Living Trust does define. Under this interpretation, the Living Trust still existed when Castellano filed her petition because the Trust Estate had not been settled–among other things, Del Alcazar had yet to make any distributions.

Defendants' interpretation of "estate" is not consistent with other provisions of the trust. Section 4.10 gives the trustee the power "to make loans and advancements from the Trust Estate to the executor or other representative of the Trustor's estate, with or without security." This provision makes plain that "estate" and "Trust Estate" are distinct concepts under the Living Trust. At the same time, though, Safanda's contention that the Living Trust terminated upon Campbell's death also does not make sense in the context of this trust. Such an interpretation would completely frustrate the Living Trust's many other directives and, for that reason, could not have been what Campbell intended. See Harris Trust & Savings Bank v. Donovan, 145 Ill.2d 166, 172 (1991) ("The first purpose in construing a trust is to discover the settlor's intent from the trust as a whole, which the court will effectuate if it is not contrary to public policy."); Epworth Children's Home v. Beasley, 365 S.C. 157, 166 (2005) (same); Furmanski v. Furmanski, 196 Wis.2d 210, 215 (Ct.App.1995) (same).

Section 9.01 of the Living Trust, like sec. 8.01, is triggered "[u]pon the death of Faith F. Campbell and upon settlement of her estate." Rather than terminate the trust, however, sec. 9.01 directs the successor trustee to "divide and distribute as a class gift, free of Trust, the remaining Trust Estate." Thus, as Safanda would have it, the very moment the successor trustee is supposed to begin the process of dividing up the Trust Estate and distributing it to the beneficiaries (forgetting for a moment that a successor trustee must be appointed in the first place), the Living Trust would itself terminate, leaving the erstwhile "Trust Estate" with no legal owner and no legal trustee.

This Catch–22 would apply with equal force, furthermore, to the Living Trust's numerous other provisions that instruct the successor trustee to accomplish certain tasks following Campbell's death but before final distribution of the Trust Estate. See, e.g., [53–1] secs. 4.06 (collect any prior loans made using Trust funds); 4.08 (pay all fees incurred in management of Trust Estate); 4.09 (pay all property taxes incurred by the Trust Estate); 7.01 (pay Campbell's funeral expenses); 7.02(a) (pay any inheritance, estate, or other death taxes); 7.02(c) (seek contribution for federal and state inheritance, succession, transfer or estate taxes).

Campbell did not intend such an outcome. See Harris Trust, 145 Ill.2d at 172 ("If possible, the court should construe the will or trust so that no language used by the testator is treated as surplusage or rendered void or insignificant."). While the precise contours of sec. 8.01 remain unclear, the provision does not cut short, preclude, or otherwise undermine the successor trustee's ability to accomplish the Living Trust's post-death instructions, including the instruction to equally distribute the Trust Estate to the beneficiaries.

On the day Castellano filed for bankruptcy, Del Alcazar had not yet made any distributions. Consistent with the reading that best reflects Campbell's overall intent, the Living Trust was still in effect and Castellano had a beneficial interest in it.

The Living Trust sought to restrict transfers of its beneficiaries' interests

*5 There is no doubt the Living Trust sought to restrict the transfer of its beneficiaries' interests. That requirement of sec. 541(c)(2) is therefore satisfied. Nevertheless, it is worth noting a distinction that has for the most part been ignored: Although all of sec. 10.03 is entitled "Spendthrift Provision," the section actually contains two distinct provisions that independently restrict transfers of the beneficiaries' interests, and only one of which is a spendthrift provision.

The first part of sec. 10.03 is the traditional spendthrift clause. It precludes all voluntary and involuntary transfers of interests. It prevents beneficiaries from alienating their interests in the Living Trust, and it prevents creditors from getting their hands on the same. The second part of sec. 10.03, by contrast, purports to convert a beneficiary's unrestricted interest in the Living Trust into a discretionary one. Such a conversion is not the work of a traditional spendthrift provision; instead, it is more appropriately thought of as establishing a conditional discretionary trust. Compare Uniform Trust Code sec. 502 ("Spendthrift Provision") with sec. 504 ("Discretionary Trusts").

So, on the question of whether the Living Trust sought to restrict the transfer of its beneficiaries' interests, the precise answer is: Yes, twice.

The Living Trust's transfer restrictions were enforceable under applicable state law

Property is excluded under sec. 541(c)(2) only if the relevant transfer restriction is valid under "applicable nonbankruptcy law"–here, state law. The parties in this case debate which state's laws apply. South Carolina, Illinois, and Wisconsin are all offered up as possibilities, but the outcome is the same no matter which you choose: The day Castellano filed for bankruptcy, transfer of her interest in the Living Trust was validly restricted by the spendthrift and discretionary trust provisions.

Spendthrift provisions were valid under South Carolina, Illinois, and Wisconsin law

In South Carolina, Illinois, and Wisconsin, a spendthrift provision will validly protect against an involuntary transfer of interests (genuinely held in trust) if (1) the trust is not self-settled and (2) the spendthrift provision restricts both voluntary and involuntary transfers. S.C.C.L. sec. 62–7–502(a); In re Marriage of Chapman, 297 Ill.App.3d 611, 618–20 (1st Dist.1998); In re Marriage of Sharp, 369 Ill.App.3d 271, 281 (2d Dist.2006); Wisc. Stat. sec. 701.06(1) (2011).

Safanda, relying on In re Lunkes, 427 B.R. 425 (N.D.Ill.2010), first contends that the Living Trust's spendthrift provision was not valid as to Castellano because it was never valid as to Campbell. Lunkes and Safanda frame the issue as whether "a trust that is not–and cannot be–a spendthrift trust at the moment of creation can convert itself into a spendthrift trust at a later date." Lunkes, 427 B.R. at 430. But the issue is not whether the Living Trust was or was not a "spendthrift trust." The question is whether a specific provision was valid as to a specific person's interest at a specific point in time. Along these same lines, no case cited in Lunkes or presented by Safanda holds that a spendthrift provision in a revocable living trust is per se invalid as to remainder beneficiaries. Such an overbroad rule would be inconsistent with the universal acceptance of non-self-settled spendthrift provisions. It would also do nothing to address the conduct the self-settled-trust rule is meant to undermine: debtors "t[ying] up property in such a way that [they] can enjoy it but prevent creditors from reaching it." Cameron v. Ewing, 424 N.J.Super. 396, 408 (App.Div.2012). Finally, although cases in Illinois (the source of law in Lunkes ) do not squarely address the issue, the state's limited treatment of this scenario takes for granted that Safanda's premise is not the correct one. See Marriage of Stevens, 292 Ill.App.3d 994 (4th Dist.1997) (recognizing that originally invalid spendthrift provision was valid as to a remainder beneficiary, but applying statutory child-support exception).

*6 Safanda next argues that the spendthrift provision stopped protecting Castellano's interest in the Living Trust once Del Alcazar was legally permitted to make distributions of the Trust Estate. This argument fails because, under the laws of the three relevant states, spendthrift provisions continue to restrict transfers of interests at least until a distribution is mandated or declared by the trustee– neither of which happened here.

The rules on spendthrift provisions are most clear in South Carolina, which adopted the Uniform Trust Code in 2006. There, a valid spendthrift provision continues to block an involuntary transfer of a trust interest until the beneficiary actually receives the distribution. See S.C.C.L. sec. 62–7–502(c) ("A beneficiary may not transfer an interest in a trust in violation of a valid spendthrift provision and, except as otherwise provided in this article, a creditor or assignee of the beneficiary may not reach the interest or a distribution by the trustee before its receipt by the beneficiary."). South Carolina law does allow a creditor to reach unreasonably delayed mandatory distributions, S.C.C.L. sec. 62–7–506, but there is no evidence of that occurring here.

No Illinois statute specifically addresses spendthrift provisions. Instead, the state's rules are based partly on the common law, see Rush University Medical Center v. Sessions, 2012 IL 112906 para. 20, and partly on its Code of Civil Procedure, see 735 ILCS 5/2–1403. Section 2–1403, which is entitled "Judgment debtor as beneficiary of trust," states that "No court ... shall order the satisfaction of a judgment out of any property held in trust for the judgment debtor if such trust has, in good faith, been created by, or the fund so held in trust has proceeded from, a person other than the judgment debtor....").

Given this relatively limited authority on spendthrift provisions, the scope of spendthrift protection in Illinois is far from clear. State decisional law suggests, however, that a creditor may reach spendthrift-protected interests only after the interest has been distributed by the trustee. See In re Marriage of Sharp 369 Ill.App.3d 271, 281 (2d Dist.2006); Community Bank of Elmhurst v. Klein, 2014 IL App (2d) 121074, paras. 11–16. In Sharp, the court held that spendthrift protections end once the beneficiary has "access to the trust assets." Sharp, 369 Ill.App.3d at 281. The defendant in that case had access to the trust assets, the court held, once trust income was paid to him, "[f]or where a trust beneficiary receives a distribution, this unfettered right of control negates any future effect of the spendthrift clause." Id. Likewise, in Klein, the court distinguished between funds that were still "in the hands of the trustee" and funds that had been "distributed from the trust," with only the latter being reachable by creditors. 2014 IL App (2d) 121074 at para. 16.

In this case, Castellano neither received any distributions from Del Alcazar, nor otherwise had access to the Trust Estate. Although she was a beneficiary and almost certainly would have had access at some point (i.e., an "unfettered right of control"), Del Alcazar's duty to divide the Trust Estate (which involved liquidating real property), combined with his discretion to "retain any property placed in Trust by Trustor for as long as [he] deem[ed] advisable," precluded Castellano from ever having access to the trust funds at any point before she filed for bankruptcy. See [53–1] secs. 4.01, 9.01. Nor did Del Alcazar's act of segregating a quarter of the Trust Estate into a second account at Merrill Lynch constitute a distribution to Castellano. The funds remained the property of the Living Trust and subject to Del Alcazar's discretion. His act of moving these funds gave Castellano no greater access to them.4

*7 As for Wisconsin, in 2011 the state's law on the involuntary transfer of interests in trust principal was as follows:

The interest in principal ... cannot be assigned and is exempt from claims against the beneficiary, but a judgment creditor, after any payments of principal have become due or payable to the beneficiary pursuant to the terms of the trust, may apply to the court for an order directing the trustee to satisfy the judgment out of any such payments and the court in its discretion may issue an order for payment of part or all of the judgment.

Wisc. Stat. sec. 701.06(2) (2011).

No Wisconsin case has interpreted the phrase "due or payable" as used in this subsection. In In re McCoy, however, a federal bankruptcy court sitting in Wisconsin held that "the phrase 'due or payable' was intended to mean mandatory payments under the terms of the trust," i.e., "those that a beneficiary is entitled to receive, or payments that have been declared by a trustee with discretion to do so." 464 B.R. 832, 839 (Bankr.W.D.Wis.2011). The court arrived at this construction by comparing sec. 701.06(2) to a nearby provision on self-settled trusts, under which judgment creditors could reach "payments of income or principal as they are due, presently or in the future, or which are payable in the trustee's discretion...." Wisc. Stat. sec. 701.06(6)(a) (2011). According to the court, this slight contrast in language, coupled with the larger statute's "apparent purpose ... to include different treatments for interest payments, distributions of principal, and protection of self-settled trusts," "suggests that the legislature intended relatively more spendthrift protection for principal distributions" than for self-settled trusts. McCoy, 464 B.R. at 839.

This makes sense. Section 701.06(2)'s reference to "payments of principal [that] have become due or payable to the beneficiary" therefore means principal that the trustee declares will be distributed, or principal the trustee must distribute immediately. In this case, the Trust Estate distributions were subject to Del Alcazar's timing discretion, see [53–1] secs. 4.01, 9.01, so they were not "mandatory."5 Likewise, Del Alcazar never declared any distributions to Castellano. The day Castellano filed for bankruptcy, her interest in the Living Trust remained protected under Wisconsin law as well.

Discretionary trusts were valid under South Carolina, Illinois, and Wisconsin law

In all three states, discretionary trusts, like spendthrift provisions, validly restrict the transfer of a beneficiary's interest. This rule is most clear in South Carolina where, having adopted the Uniform Trust Code, state statute makes explicit that discretionary trusts are valid and cannot ordinarily be reached by a beneficiary's creditors. S.C.C.L. sec. 62–7–504(b).

The issue is less straightforward in Illinois and Wisconsin. The Illinois Compiled Statutes do not specifically address the validity or effect of discretionary trusts. But the laws do allow child-support creditors to reach such assets, which itself suggests that other creditors ordinarily cannot. 735 ILCS 5/2–1403(1)–(2); Stevens, 292 Ill.App.3d 994, 1001 (4th Dist.1997). That inference is also supported by the fact that the language of 735 ILCS 5/2–1403 fits discretionary trusts just as well as it fits spendthrift provisions; the only test being whether the trust in question was created in good faith by "a person other than the judgment debtor." Finally, although no Illinois case substantively explores the protections provided by discretionary trusts, several decisions state or imply that such trusts generally are protected against the reach of creditors. See, e.g., Button v. Elmhurst National Bank, 169 Ill.App.3d 28, 40 (2d Dist.1988) (" 'Admittedly, the beneficiary of a discretionary trust for care, comfort, maintenance or well-being is endowed with no property which an ordinary creditor may reach.' ") (quoting Bureau of Support v. Kreitzer, 16 Ohio St.2d 147, 150 (1968)); Estate of McInerny, 289 Ill.App.3d 589, 598 (1st Dist.1997) (holding that a creditor could not reach funds held in a "discretionary supplemental support trust with a spendthrift provision."); Goodpasteur v. Fried, 183 Ill.App.3d 491, 496 (1st Dist.1989) (McNamara, J., dissenting) ("The trust also directs that the trustees distribute funds only as they shall determine in their sole discretion. This is known as a discretionary trust.... [I]n such a discretionary trust, the beneficiary holds no vested interest until the trustees decide to make a payment to the beneficiary.").

*8 Like Illinois, Wisconsin did not have a statute affirmatively addressing discretionary trusts in 2011. But it too allowed access to discretionary-trust funds under certain circumstances, see Wisc. Stat. sec. 701.06(4)(b) (2011) (for child support); sec. 701.06(5)(b) (2011) (to repay public support of beneficiary), which again suggests a general rule of no access. This inference, furthermore, is supported by Wisconsin case law. See Grohmann v. Grohmann, 180 Wis.2d 690, 694–95 (Wis.App.1993) (affirming trial court's determination that it had no authority to order payment of child support by discretionary trust prior to trustee deciding to authorize a distribution).

Because on the day Castellano filed for bankruptcy the laws of South Carolina, Illinois, and Wisconsin all acknowledged the ability of discretionary trusts to restrict the transfer of a beneficiary's interest, sec. 10.03's discretionary trust language also constituted a valid restriction on the transfer of Castellano's interest under applicable nonbankruptcy law.

Regardless of whether the Living Trust's conditional discretionary-trust language was triggered, Castellano had a beneficial interest in a trust subject to a valid nonbankruptcy restriction on transfer. Therefore, her interest in the Living Trust fell within the scope of sec. 541(c)(2) and is excluded from her bankruptcy estate.

B. Section 548(e)

The record does not support application of sec. 548(e) in this case. "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." 11 U.S.C. sec. 548(e). At all times, Castellano's potential share remained the property of the Living Trust in the custody of Merrill Lynch. Although Safanda segregated a portion of the Living Trust into a second account at Merrill Lynch earmarked for potential discretionary distributions to Castellano, that act did not end the Living Trust's ownership of those funds, constitute a distribution to Castellano, or create a new trust. It was simply a division of trust property as permitted by sec. 4.02(b) of the Living Trust. Accordingly, because there was no transfer of an interest of the debtor, sec. 548(e) does not apply.

IV. Conclusion

Castellano and Del Alcazar's objections to the bankruptcy court's proposed findings of facts and conclusions of law are sustained. Enter judgment for defendants, and terminate civil case.


Footnotes


1

By way of example, the high court has found individual interests or rights to be "particularly important"–such that the higher standard applies–in proceedings to terminate parental rights, Santosky v. Kramer, 455 U.S. 745 (1982), for involuntary commitment, Addington v. Texas, 441 U.S. 418 (1979), and for deportation, Woodby v. INS, 385 U.S. 276 (1966). By contrast, proceedings that might have imposed severe civil sanctions did not implicate such heightened interests. See, e.g., Steadman v. S.E.C., 450 U.S. 91 (1981) (order permanently barring an individual from practicing his profession called for preponderance standard); S.E.C. v. C.M. Joiner Leasing Corp., 320 U.S. 344 (1943) (preponderance standard applied to civil case in which conduct to be proved was also criminal).


2

Citations to docket entries [50] and [53–x] refer to the bankruptcy court's docket in Safanda v. Castellano, et al., 2013–A–01257 (Bankr.N.D.Ill.). All other docket citations refer to this court's docket. Page citations refer to the page numbers displayed in the cited exhibit's CM/ECF header.


3

Safanda argues in passing that Castellano "did not claim an exemption of the Spendthrift Trust under South Carolina law or Section 541(c)(2)" in her bankruptcy petition. [5] at 5. That is true. On Schedule C of her petition, Castellano (or her attorney) cited 735 ILCS 5/12–1001(h)(3)–a wholly inapplicable Illinois law pertaining to payments made to a dependent under a life insurance policy. Safanda offers no authority for the rule, however, that such a miscitation precludes Castellano from defending against this adversary proceeding on the basis of sec. 541(c)(2)–especially when the statute was cited in the Joint Pretrial Statement and argued at trial. Moreover, "[a] voluntary petition, list, schedule, or statement may be amended by the debtor as a matter of course at any time before the case is closed." Fed. R. Bankr.P. 1009(a). The bankruptcy case remains open here, so Castellano may revise the citation at any time. Finally, property interests that fall under sec. 541(c)(2) arguably need not be listed on Schedule C ("Property Claimed As Exempt"), since such property is excluded from the bankruptcy estate, not exempted from it.


4

Del Alcazar's status as a relative-by-marriage does not mean Castellano had an unfettered right to control the trust funds. The record contains no evidence that Del Alcazar was willing to ignore the Living Trust's standard for the use of his discretion, in favor of doing whatever Castellano demanded.


5

Nor is there any evidence that Del Alcazar unreasonably delayed distributions or otherwise acted in bad faith in that regard.
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Castellano Reversed - 548(e) and Spendthrift Trust

Postby JDA » Fri May 22, 2015 7:30 pm

Safanda v. Castellano, 2015 WL 1911130 (N.D.Ill., April 27, 2015). http://goo.gl/5cU8bv

United States District Court, N.D. Illinois, Eastern Division.

Roy Safanda, Trustee in Bankruptcy, Plaintiff,

v.

Linda K. Castellano, individually, and J.T. Del Alcazar, as Successor Trustee of the Faith F. Campbell Living Trust dated February 18, 1997, Defendants.

No. 14 CV 07094 | Signed April 27, 2015

MEMORANDUM OPINION AND ORDER

Manish S. Shah, United States District Judge

*1 Plaintiff Roy Safanda is the trustee appointed to administer the bankruptcy estate of debtor-defendant Linda Castellano. In this adversary proceeding, Safanda seeks the turnover of Castellano's share of her deceased mother's Living Trust, which is being held by defendant J.T. Del Alcazar as successor trustee. The bankruptcy court below agreed with Safanda's argument that Del Alcazar's current possession of the assets is avoidable under 11 U.S.C. sec. 548(e) and that the funds should be turned over to the bankruptcy estate. Defendants Castellano and Del Alcazar objected to these proposed findings of fact and conclusions of law.

For the following reasons, I find in favor of defendants and against Safanda.

I. Legal Standards

On these claims to avoid a fraudulent transfer under 11 U.S.C. sec. 548 and for turnover under 11 U.S.C. secs. 543 and 550, brought in-part against a non-party to the bankruptcy (Del Alcazar), a district court reviews the bankruptcy court's proposed findings of fact and conclusions of law de novo. See Stern v. Marshall, ––– U.S. ––––, 131 S.Ct. 2594, 2620 (2011); Executive Benefits Insurance Agency v. Arkison, ––– U.S. ––––, 134 S.Ct. 2165, 2173 (2014); see also In re Bellingham Insurance Agency, Inc., 702 F.3d 553, 561–65 (9th Cir.2012).

Courts dispute the appropriate evidentiary standard to apply to fraudulent-transfer claims. Some say a plaintiff must prove his claim by a preponderance of the evidence. See, e.g., In re McCook Metals, L.L.C., 319 B.R. 570, 587 n.11 (Bankr.N.D.Ill.2005). Others say he must do so with clear and convincing evidence. See, e.g., In re Art Unlimited, LLC, 356 B.R. 700, 707 (Bankr.E.D.Wis.2006). The Seventh Circuit has not recently weighed in on the matter, but in a fraudulent-transfer decision dating to the 1940s, it stated in dicta that "fraud ... must be proved by clear and convincing evidence." Springmann v. Gary State Bank, 124 F.2d 678, 681 (7th Cir.1941).

The Supreme Court more recently clarified in Grogan v. Garner, that "[b]ecause the preponderance-of-the-evidence standard results in a roughly equal allocation of the risk of error between litigants, we presume that this standard is applicable in civil actions between private litigants unless 'particularly important individual interests or rights are at stake.' " 498 U.S. 279, 286 (1991) (holding that a debtor's interest in discharging debts in bankruptcy is not a sufficiently important interest to warrant the heightened standard of proof).1

*2 In light of the presumption mandated by Grogan, and because a trustee-as-creditor's interest in avoiding a fraudulent transfer is not materially more important than the interest at stake in Grogan, the preponderance-of-the-evidence standard applies in this case.

II. Facts

The Faith F. Campbell Living Trust

On February 18, 1997, Faith F. Campbell created the Faith F. Campbell Living Trust. Campbell appointed herself as initial trustee and gave herself the unrestricted authority during her lifetime "to add or withdraw assets or property of the Trust Estate." [53–1]2 secs. 1.01, 3.01. The Living Trust named Campbell as the "Income Beneficiary" and her four children–including defendant Linda Castellano–as the "Beneficiaries." Id. secs. 6.01, 9.01(b)-(c), 13.04(f). In a section called "Spendthrift Provision," the Living Trust further instructed that (id. sec. 10.03):

[N]o beneficiary of the Trust shall have any right, power, or authority to alienate, encumber, assign, or pledge his or her interest in the principal or income of the Trust in any manner. No interest of any beneficiary shall be subject to any claims of his or her creditors (including the creditors of the spouse of a married beneficiary) or liable to attachment, execution, or other process of law.... [I]f by reason of bankruptcy or insolvency ... all or any part of the income or principal might fail to be enjoyed by any beneficiary or might vest in or be enjoyed by some other person, then the interest of that beneficiary shall immediately terminate. Thereafter, the Trustee shall pay to or for the benefit of that beneficiary only those amounts that the Trustee, in its sole and absolute discretion, deems advisable for the education and support of that beneficiary until the death of the beneficiary or the maximum period permissible under the South Carolina rule against perpetuities, whichever first occurs....

Campbell died February 11, 2011, survived by all four of her children. [53–5] at 1–2. The Living Trust originally named Merrill Lynch Trust Company of North Carolina as successor trustee, but that entity–having been absorbed by Bank of America–declined to take the job. Id. It therefore fell to the four beneficiaries to appoint a replacement, and together they chose defendant J.T. Del Alcazar–the husband of Castellano's niece. [50] at 62:15–34:8.

Castellano's Financial Problems

For 37 years, Castellano and her husband owned and operated a moving business called Peacock Relocation Services. [50] at 46:13–15. Peacock began experiencing financial difficulties in 2008 due to the recession, which eventually led to its closure in the summer of 2011. Id. at 46:9–24. By that following fall, Castellano and her husband decided that they needed to file for bankruptcy. Id. at 47:14–15.

On October 5, 2011, an attorney representing Castellano sent a letter to an attorney for Del Alcazar, stating ( [53–9] at 1):

I am writing to you in relation to section 10.03 of the trust [i.e., the "Spendthrift Provision"], to advise you that my client Linda Castellano and her husband have experienced insolvency due to the recession. They have closed their business and are filing for bankruptcy protection. Linda Castellano considers that it is the trustee's obligation to exercise his authority consistent with the provisions of the trust identified above.

*3 Upon receiving this letter, Del Alcazar "took it upon [him]self" to move approximately $400,000 (one-quarter of the Trust Estate) from the primary account at Merrill Lynch to a second account at the same institution. [50] at 96:8–12; 100:37; 101:13–103:16. Del Alcazar named the second, smaller account the "Faith F. Campbell Spendthrift Trust [for the benefit of] Linda Castellano." Id. at 101:21–25; [53–6] at 12. Although Del Alcazar characterized this second account as a "Spendthrift Trust"–which could suggest that it constituted a newly settled trust– the record evidence demonstrates that no new trust was created. Del Alcazar simply moved a portion of the Trust Estate from one account to another, as he was empowered to do by the terms of the Living Trust. See [53–1] sec. 4.02(b).

On November 18, 2011, Castellano and her husband filed voluntary Chapter 7 bankruptcy petitions. See In re Bruno and Linda K. Castellano, 11–BK–46854 (Bankr.N.D.Ill.). Three days later, Castellano signed a document entitled "Receipt, Approval of Accounting, Release and Discharge of Trustee." [53–6]. As the name suggests, the document acknowledged that Castellano had received an accounting from Del Alcazar, approved Del Alcazar's proposed distribution of the Trust Estate, and released Del Alcazar from any claims. Id. at 1–2. Castellano also agreed that (1) her interest in the Living Trust under sec. 9.01 was terminated pursuant to sec. 10.03; (2) she had become a "life-time, limited beneficiary at the sole discretion of the trustee" of the Living Trust; (3) her insolvency required the trustee to retain her interest pursuant to the "Spendthrift Provision"; and (4) she would receive no distribution from the Living Trust, but that the "Spendthrift Trust" (i.e., the second account at Merrill Lynch) would receive her "life-time, limited beneficial interest ... in full satisfaction of [her] rights and interests under the Living Trust, [but] reserving [her] beneficial interests pursuant to the Spendthrift Trust." Id. at 1.

In December 2011, Del Alcazar made distributions from the Trust Estate to Castellano's three siblings. [50] at 43:19–24; 61:24–62:3; 94:1–6. He never made a distribution to Castellano. Id.

Adversary Proceeding

On October 25, 2013, plaintiff Roy Safanda, the trustee appointed to administer Castellano's bankruptcy estate, instituted an adversary proceeding against Castellano and Del Alcazar. See Safanda v. Castellano, et al., 2013–A–01257 (Bankr.N.D.Ill.). Count I of Safanda's complaint seeks to avoid the transfer of the assets to the "Spendthrift Trust" under 11 U.S.C. sec. 548(e). Count II seeks turnover of those assets to Castellano's bankruptcy estate.

After a trial, the bankruptcy court entered Proposed Findings of Fact and Conclusions of Law, in which it recommended that judgment be entered in favor of Safanda on both counts. Castellano and Del Alcazar timely objected.

III. Analysis

A. Section 541(c)(2)

When a debtor files for bankruptcy, it automatically creates an estate containing "all legal or equitable interests of the debtor in property as of the commencement of the case." 11 U.S.C. sec. 541(a)(1). Section 541(c)(2) is an exception to this rule. Property of the debtor that would otherwise be transferable is not transferred to the bankruptcy estate if: (1) it consists of a beneficial interest in a trust, (2) the trust agreement contains language restricting the transfer of the interest, and (3) the transfer restriction is enforceable under "applicable nonbankruptcy law." See 11 U.S.C. sec. 541(c)(2).

The parties cited sec. 541(c)(2) in their Joint Pretrial Statement and, although not discussed in the bankruptcy court's recommendation, this section should be considered in this case. If a trust-interest is excluded from the bankruptcy estate under sec. 541(c)(2), the bankruptcy trustee has no basis to avoid its transfer. See, e.g., In re Hill, 342 B.R. 183, 206 (Bankr.D.N.J.2006) ("Even accepting the Trustee's theory that Phyllis transferred a 17% interest in Daniel's pension that should have been hers in equitable distribution, avoiding that transfer would not make any assets available for creditors."); see also Matter of McClellan, 99 F.3d 1420, 1423 (7th Cir.1996) ("Bankruptcy courts do not have subject matter jurisdiction and cannot administer property excluded from or outside the bankruptcy estate."). If sec. 541(c)(2) applies, then Safanda cannot pursue the transfer and turnover claims.3

Castellano's interest was in a trust

*4 Safanda indirectly argues that the day Castellano filed for bankruptcy, she had no interest in the Living Trust because it had already terminated. Section 8.01 of the Living Trust states that "[u]pon the death of Faith F. Campbell and upon settlement of her estate, this Trust shall terminate." The Living Trust does not define "estate," but Safanda believes it should be taken to mean "probate estate." Since no probate estate was opened here, Safanda believes the conditions of sec. 8.01 were satisfied the day Campbell passed away. If true, it would mean the trust terminated months before Castellano filed her petition, thereby precluding her from having an interest in the trust at filing. Defendants reject this interpretation. They think the word "estate" is better understood to mean "Trust Estate," which the Living Trust does define. Under this interpretation, the Living Trust still existed when Castellano filed her petition because the Trust Estate had not been settled–among other things, Del Alcazar had yet to make any distributions.

Defendants' interpretation of "estate" is not consistent with other provisions of the trust. Section 4.10 gives the trustee the power "to make loans and advancements from the Trust Estate to the executor or other representative of the Trustor's estate, with or without security." This provision makes plain that "estate" and "Trust Estate" are distinct concepts under the Living Trust. At the same time, though, Safanda's contention that the Living Trust terminated upon Campbell's death also does not make sense in the context of this trust. Such an interpretation would completely frustrate the Living Trust's many other directives and, for that reason, could not have been what Campbell intended. See Harris Trust & Savings Bank v. Donovan, 145 Ill.2d 166, 172 (1991) ("The first purpose in construing a trust is to discover the settlor's intent from the trust as a whole, which the court will effectuate if it is not contrary to public policy."); Epworth Children's Home v. Beasley, 365 S.C. 157, 166 (2005) (same); Furmanski v. Furmanski, 196 Wis.2d 210, 215 (Ct.App.1995) (same).

Section 9.01 of the Living Trust, like sec. 8.01, is triggered "[u]pon the death of Faith F. Campbell and upon settlement of her estate." Rather than terminate the trust, however, sec. 9.01 directs the successor trustee to "divide and distribute as a class gift, free of Trust, the remaining Trust Estate." Thus, as Safanda would have it, the very moment the successor trustee is supposed to begin the process of dividing up the Trust Estate and distributing it to the beneficiaries (forgetting for a moment that a successor trustee must be appointed in the first place), the Living Trust would itself terminate, leaving the erstwhile "Trust Estate" with no legal owner and no legal trustee.

This Catch–22 would apply with equal force, furthermore, to the Living Trust's numerous other provisions that instruct the successor trustee to accomplish certain tasks following Campbell's death but before final distribution of the Trust Estate. See, e.g., [53–1] secs. 4.06 (collect any prior loans made using Trust funds); 4.08 (pay all fees incurred in management of Trust Estate); 4.09 (pay all property taxes incurred by the Trust Estate); 7.01 (pay Campbell's funeral expenses); 7.02(a) (pay any inheritance, estate, or other death taxes); 7.02(c) (seek contribution for federal and state inheritance, succession, transfer or estate taxes).

Campbell did not intend such an outcome. See Harris Trust, 145 Ill.2d at 172 ("If possible, the court should construe the will or trust so that no language used by the testator is treated as surplusage or rendered void or insignificant."). While the precise contours of sec. 8.01 remain unclear, the provision does not cut short, preclude, or otherwise undermine the successor trustee's ability to accomplish the Living Trust's post-death instructions, including the instruction to equally distribute the Trust Estate to the beneficiaries.

On the day Castellano filed for bankruptcy, Del Alcazar had not yet made any distributions. Consistent with the reading that best reflects Campbell's overall intent, the Living Trust was still in effect and Castellano had a beneficial interest in it.

The Living Trust sought to restrict transfers of its beneficiaries' interests

*5 There is no doubt the Living Trust sought to restrict the transfer of its beneficiaries' interests. That requirement of sec. 541(c)(2) is therefore satisfied. Nevertheless, it is worth noting a distinction that has for the most part been ignored: Although all of sec. 10.03 is entitled "Spendthrift Provision," the section actually contains two distinct provisions that independently restrict transfers of the beneficiaries' interests, and only one of which is a spendthrift provision.

The first part of sec. 10.03 is the traditional spendthrift clause. It precludes all voluntary and involuntary transfers of interests. It prevents beneficiaries from alienating their interests in the Living Trust, and it prevents creditors from getting their hands on the same. The second part of sec. 10.03, by contrast, purports to convert a beneficiary's unrestricted interest in the Living Trust into a discretionary one. Such a conversion is not the work of a traditional spendthrift provision; instead, it is more appropriately thought of as establishing a conditional discretionary trust. Compare Uniform Trust Code sec. 502 ("Spendthrift Provision") with sec. 504 ("Discretionary Trusts").

So, on the question of whether the Living Trust sought to restrict the transfer of its beneficiaries' interests, the precise answer is: Yes, twice.

The Living Trust's transfer restrictions were enforceable under applicable state law

Property is excluded under sec. 541(c)(2) only if the relevant transfer restriction is valid under "applicable nonbankruptcy law"–here, state law. The parties in this case debate which state's laws apply. South Carolina, Illinois, and Wisconsin are all offered up as possibilities, but the outcome is the same no matter which you choose: The day Castellano filed for bankruptcy, transfer of her interest in the Living Trust was validly restricted by the spendthrift and discretionary trust provisions.

Spendthrift provisions were valid under South Carolina, Illinois, and Wisconsin law

In South Carolina, Illinois, and Wisconsin, a spendthrift provision will validly protect against an involuntary transfer of interests (genuinely held in trust) if (1) the trust is not self-settled and (2) the spendthrift provision restricts both voluntary and involuntary transfers. S.C.C.L. sec. 62–7–502(a); In re Marriage of Chapman, 297 Ill.App.3d 611, 618–20 (1st Dist.1998); In re Marriage of Sharp, 369 Ill.App.3d 271, 281 (2d Dist.2006); Wisc. Stat. sec. 701.06(1) (2011).

Safanda, relying on In re Lunkes, 427 B.R. 425 (N.D.Ill.2010), first contends that the Living Trust's spendthrift provision was not valid as to Castellano because it was never valid as to Campbell. Lunkes and Safanda frame the issue as whether "a trust that is not–and cannot be–a spendthrift trust at the moment of creation can convert itself into a spendthrift trust at a later date." Lunkes, 427 B.R. at 430. But the issue is not whether the Living Trust was or was not a "spendthrift trust." The question is whether a specific provision was valid as to a specific person's interest at a specific point in time. Along these same lines, no case cited in Lunkes or presented by Safanda holds that a spendthrift provision in a revocable living trust is per se invalid as to remainder beneficiaries. Such an overbroad rule would be inconsistent with the universal acceptance of non-self-settled spendthrift provisions. It would also do nothing to address the conduct the self-settled-trust rule is meant to undermine: debtors "t[ying] up property in such a way that [they] can enjoy it but prevent creditors from reaching it." Cameron v. Ewing, 424 N.J.Super. 396, 408 (App.Div.2012). Finally, although cases in Illinois (the source of law in Lunkes ) do not squarely address the issue, the state's limited treatment of this scenario takes for granted that Safanda's premise is not the correct one. See Marriage of Stevens, 292 Ill.App.3d 994 (4th Dist.1997) (recognizing that originally invalid spendthrift provision was valid as to a remainder beneficiary, but applying statutory child-support exception).

*6 Safanda next argues that the spendthrift provision stopped protecting Castellano's interest in the Living Trust once Del Alcazar was legally permitted to make distributions of the Trust Estate. This argument fails because, under the laws of the three relevant states, spendthrift provisions continue to restrict transfers of interests at least until a distribution is mandated or declared by the trustee– neither of which happened here.

The rules on spendthrift provisions are most clear in South Carolina, which adopted the Uniform Trust Code in 2006. There, a valid spendthrift provision continues to block an involuntary transfer of a trust interest until the beneficiary actually receives the distribution. See S.C.C.L. sec. 62–7–502(c) ("A beneficiary may not transfer an interest in a trust in violation of a valid spendthrift provision and, except as otherwise provided in this article, a creditor or assignee of the beneficiary may not reach the interest or a distribution by the trustee before its receipt by the beneficiary."). South Carolina law does allow a creditor to reach unreasonably delayed mandatory distributions, S.C.C.L. sec. 62–7–506, but there is no evidence of that occurring here.

No Illinois statute specifically addresses spendthrift provisions. Instead, the state's rules are based partly on the common law, see Rush University Medical Center v. Sessions, 2012 IL 112906 para. 20, and partly on its Code of Civil Procedure, see 735 ILCS 5/2–1403. Section 2–1403, which is entitled "Judgment debtor as beneficiary of trust," states that "No court ... shall order the satisfaction of a judgment out of any property held in trust for the judgment debtor if such trust has, in good faith, been created by, or the fund so held in trust has proceeded from, a person other than the judgment debtor....").

Given this relatively limited authority on spendthrift provisions, the scope of spendthrift protection in Illinois is far from clear. State decisional law suggests, however, that a creditor may reach spendthrift-protected interests only after the interest has been distributed by the trustee. See In re Marriage of Sharp 369 Ill.App.3d 271, 281 (2d Dist.2006); Community Bank of Elmhurst v. Klein, 2014 IL App (2d) 121074, paras. 11–16. In Sharp, the court held that spendthrift protections end once the beneficiary has "access to the trust assets." Sharp, 369 Ill.App.3d at 281. The defendant in that case had access to the trust assets, the court held, once trust income was paid to him, "[f]or where a trust beneficiary receives a distribution, this unfettered right of control negates any future effect of the spendthrift clause." Id. Likewise, in Klein, the court distinguished between funds that were still "in the hands of the trustee" and funds that had been "distributed from the trust," with only the latter being reachable by creditors. 2014 IL App (2d) 121074 at para. 16.

In this case, Castellano neither received any distributions from Del Alcazar, nor otherwise had access to the Trust Estate. Although she was a beneficiary and almost certainly would have had access at some point (i.e., an "unfettered right of control"), Del Alcazar's duty to divide the Trust Estate (which involved liquidating real property), combined with his discretion to "retain any property placed in Trust by Trustor for as long as [he] deem[ed] advisable," precluded Castellano from ever having access to the trust funds at any point before she filed for bankruptcy. See [53–1] secs. 4.01, 9.01. Nor did Del Alcazar's act of segregating a quarter of the Trust Estate into a second account at Merrill Lynch constitute a distribution to Castellano. The funds remained the property of the Living Trust and subject to Del Alcazar's discretion. His act of moving these funds gave Castellano no greater access to them.4

*7 As for Wisconsin, in 2011 the state's law on the involuntary transfer of interests in trust principal was as follows:

The interest in principal ... cannot be assigned and is exempt from claims against the beneficiary, but a judgment creditor, after any payments of principal have become due or payable to the beneficiary pursuant to the terms of the trust, may apply to the court for an order directing the trustee to satisfy the judgment out of any such payments and the court in its discretion may issue an order for payment of part or all of the judgment.

Wisc. Stat. sec. 701.06(2) (2011).

No Wisconsin case has interpreted the phrase "due or payable" as used in this subsection. In In re McCoy, however, a federal bankruptcy court sitting in Wisconsin held that "the phrase 'due or payable' was intended to mean mandatory payments under the terms of the trust," i.e., "those that a beneficiary is entitled to receive, or payments that have been declared by a trustee with discretion to do so." 464 B.R. 832, 839 (Bankr.W.D.Wis.2011). The court arrived at this construction by comparing sec. 701.06(2) to a nearby provision on self-settled trusts, under which judgment creditors could reach "payments of income or principal as they are due, presently or in the future, or which are payable in the trustee's discretion...." Wisc. Stat. sec. 701.06(6)(a) (2011). According to the court, this slight contrast in language, coupled with the larger statute's "apparent purpose ... to include different treatments for interest payments, distributions of principal, and protection of self-settled trusts," "suggests that the legislature intended relatively more spendthrift protection for principal distributions" than for self-settled trusts. McCoy, 464 B.R. at 839.

This makes sense. Section 701.06(2)'s reference to "payments of principal [that] have become due or payable to the beneficiary" therefore means principal that the trustee declares will be distributed, or principal the trustee must distribute immediately. In this case, the Trust Estate distributions were subject to Del Alcazar's timing discretion, see [53–1] secs. 4.01, 9.01, so they were not "mandatory."5 Likewise, Del Alcazar never declared any distributions to Castellano. The day Castellano filed for bankruptcy, her interest in the Living Trust remained protected under Wisconsin law as well.

Discretionary trusts were valid under South Carolina, Illinois, and Wisconsin law

In all three states, discretionary trusts, like spendthrift provisions, validly restrict the transfer of a beneficiary's interest. This rule is most clear in South Carolina where, having adopted the Uniform Trust Code, state statute makes explicit that discretionary trusts are valid and cannot ordinarily be reached by a beneficiary's creditors. S.C.C.L. sec. 62–7–504(b).

The issue is less straightforward in Illinois and Wisconsin. The Illinois Compiled Statutes do not specifically address the validity or effect of discretionary trusts. But the laws do allow child-support creditors to reach such assets, which itself suggests that other creditors ordinarily cannot. 735 ILCS 5/2–1403(1)–(2); Stevens, 292 Ill.App.3d 994, 1001 (4th Dist.1997). That inference is also supported by the fact that the language of 735 ILCS 5/2–1403 fits discretionary trusts just as well as it fits spendthrift provisions; the only test being whether the trust in question was created in good faith by "a person other than the judgment debtor." Finally, although no Illinois case substantively explores the protections provided by discretionary trusts, several decisions state or imply that such trusts generally are protected against the reach of creditors. See, e.g., Button v. Elmhurst National Bank, 169 Ill.App.3d 28, 40 (2d Dist.1988) (" 'Admittedly, the beneficiary of a discretionary trust for care, comfort, maintenance or well-being is endowed with no property which an ordinary creditor may reach.' ") (quoting Bureau of Support v. Kreitzer, 16 Ohio St.2d 147, 150 (1968)); Estate of McInerny, 289 Ill.App.3d 589, 598 (1st Dist.1997) (holding that a creditor could not reach funds held in a "discretionary supplemental support trust with a spendthrift provision."); Goodpasteur v. Fried, 183 Ill.App.3d 491, 496 (1st Dist.1989) (McNamara, J., dissenting) ("The trust also directs that the trustees distribute funds only as they shall determine in their sole discretion. This is known as a discretionary trust.... [I]n such a discretionary trust, the beneficiary holds no vested interest until the trustees decide to make a payment to the beneficiary.").

*8 Like Illinois, Wisconsin did not have a statute affirmatively addressing discretionary trusts in 2011. But it too allowed access to discretionary-trust funds under certain circumstances, see Wisc. Stat. sec. 701.06(4)(b) (2011) (for child support); sec. 701.06(5)(b) (2011) (to repay public support of beneficiary), which again suggests a general rule of no access. This inference, furthermore, is supported by Wisconsin case law. See Grohmann v. Grohmann, 180 Wis.2d 690, 694–95 (Wis.App.1993) (affirming trial court's determination that it had no authority to order payment of child support by discretionary trust prior to trustee deciding to authorize a distribution).

Because on the day Castellano filed for bankruptcy the laws of South Carolina, Illinois, and Wisconsin all acknowledged the ability of discretionary trusts to restrict the transfer of a beneficiary's interest, sec. 10.03's discretionary trust language also constituted a valid restriction on the transfer of Castellano's interest under applicable nonbankruptcy law.

Regardless of whether the Living Trust's conditional discretionary-trust language was triggered, Castellano had a beneficial interest in a trust subject to a valid nonbankruptcy restriction on transfer. Therefore, her interest in the Living Trust fell within the scope of sec. 541(c)(2) and is excluded from her bankruptcy estate.

B. Section 548(e)

The record does not support application of sec. 548(e) in this case. "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." 11 U.S.C. sec. 548(e). At all times, Castellano's potential share remained the property of the Living Trust in the custody of Merrill Lynch. Although Safanda segregated a portion of the Living Trust into a second account at Merrill Lynch earmarked for potential discretionary distributions to Castellano, that act did not end the Living Trust's ownership of those funds, constitute a distribution to Castellano, or create a new trust. It was simply a division of trust property as permitted by sec. 4.02(b) of the Living Trust. Accordingly, because there was no transfer of an interest of the debtor, sec. 548(e) does not apply.

IV. Conclusion

Castellano and Del Alcazar's objections to the bankruptcy court's proposed findings of facts and conclusions of law are sustained. Enter judgment for defendants, and terminate civil case.


Footnotes


1

By way of example, the high court has found individual interests or rights to be "particularly important"–such that the higher standard applies–in proceedings to terminate parental rights, Santosky v. Kramer, 455 U.S. 745 (1982), for involuntary commitment, Addington v. Texas, 441 U.S. 418 (1979), and for deportation, Woodby v. INS, 385 U.S. 276 (1966). By contrast, proceedings that might have imposed severe civil sanctions did not implicate such heightened interests. See, e.g., Steadman v. S.E.C., 450 U.S. 91 (1981) (order permanently barring an individual from practicing his profession called for preponderance standard); S.E.C. v. C.M. Joiner Leasing Corp., 320 U.S. 344 (1943) (preponderance standard applied to civil case in which conduct to be proved was also criminal).


2

Citations to docket entries [50] and [53–x] refer to the bankruptcy court's docket in Safanda v. Castellano, et al., 2013–A–01257 (Bankr.N.D.Ill.). All other docket citations refer to this court's docket. Page citations refer to the page numbers displayed in the cited exhibit's CM/ECF header.


3

Safanda argues in passing that Castellano "did not claim an exemption of the Spendthrift Trust under South Carolina law or Section 541(c)(2)" in her bankruptcy petition. [5] at 5. That is true. On Schedule C of her petition, Castellano (or her attorney) cited 735 ILCS 5/12–1001(h)(3)–a wholly inapplicable Illinois law pertaining to payments made to a dependent under a life insurance policy. Safanda offers no authority for the rule, however, that such a miscitation precludes Castellano from defending against this adversary proceeding on the basis of sec. 541(c)(2)–especially when the statute was cited in the Joint Pretrial Statement and argued at trial. Moreover, "[a] voluntary petition, list, schedule, or statement may be amended by the debtor as a matter of course at any time before the case is closed." Fed. R. Bankr.P. 1009(a). The bankruptcy case remains open here, so Castellano may revise the citation at any time. Finally, property interests that fall under sec. 541(c)(2) arguably need not be listed on Schedule C ("Property Claimed As Exempt"), since such property is excluded from the bankruptcy estate, not exempted from it.


4

Del Alcazar's status as a relative-by-marriage does not mean Castellano had an unfettered right to control the trust funds. The record contains no evidence that Del Alcazar was willing to ignore the Living Trust's standard for the use of his discretion, in favor of doing whatever Castellano demanded.


5

Nor is there any evidence that Del Alcazar unreasonably delayed distributions or otherwise acted in bad faith in that regard.
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