Efficacy of Foreign Asset Protection Trusts

For purposes of this discussion, an asset protection trust is a form of trust that the settlor creates for himself as the beneficiary (known as "self-settling"), with his beneficial interest protected from his creditors by spendthrift provisions. In other words, it is a self-settled spendthrift trust (SSST). A foreign asset protection trust, as compared to a domestic asset protection trust, is such a trust that is created in a jurisdiction outside the United States whose laws allow for self-settled spendthrift trusts.

The statutory laws of nearly all Anglo/American jurisdictions specifically allow for trusts with spendthrift provisions, and thus there are no negative connotations for spendthrift provisions. Likewise, those same laws allow for trusts to be self-settled, i.e., one can create a trust for their own benefit. The revocable grantor trust, popularly known as a "living trust", is fundamentally a self-settled trust. So, there is no problem with spendthrift provisions per se nor with self-settled trusts per se.

The problem is with self-settled trusts that contain spendthrift provisions protecting the trust assets from the creditors of the settlor/beneficiary. In one moment, the settlor has assets that are available to satisfy the claims of his creditors, but by the simple expedient of transferring those assets to a trust for his own benefit, those assets are now protected from creditors. It is against precisely this result that the legislatures of nearly all U.S. states and U.K. commonwealth countries passed laws forbidding the spendthrift provisions from being used to protect the assets of self-settled trusts from the creditors of the settlor/beneficiary.

In a bid to attract trust formation work, the Cook Islands in 1986 adopted radical and new legislation that specifically allowed self-settled spendthrift trusts as well as a host of additional and rather blatant anti-creditor provisions. This could very well be said to be the starting point of law relating to asset protection trusts, and perhaps even the entire concept of asset protection as a specialized practice area. Other major offshore jurisdictions soon followed suit, and by the late 1990s the legislatures of Alaska, Delaware and Nevada had joined the movement, thus kicking off competition amongst some states to attract asset protection trust business.

How and Why FAPTs Fail

Yet, the problem is fundamentally that of self-settled spendthrift trusts. A few jurisdictions allow them, but most - including the most populated jurisdictions - do not. For those who are not resident and also keep all of their valuable assets in an SSST jurisdiction, the problem thus becomes fundamentally one of conflict of laws: Does the law of their jurisdiction of residence which prohibits such trusts apply, or does the law of the trust where they have formed their trust apply?

The question is fundamentally one of nexus, which is answered by the creditor's quite appealing and to-date mostly successful argument that there is no logical reason why the creditor should be disadvantaged in its collection attempts by the laws of a distant jurisdiction to which the debtor has intentionally sent his assets for the very purpose of defeating the creditor's attempts to execute upon them. Moreover, because the Settlor is a beneficiary of the trust, the courts tend to consider the trust's assets as remaining on the Settlor's balance sheet, even if he is only a discretionary beneficiary. This latter point is especially evident in the bankruptcy cases discussed below.

With FAPT cases, the courts face the practical challenge that, although the Settlor is within its jurisdiction and powers, the assets that should be available to satisfy the creditor's judgment are not. Deprived of the ability to dispose of the trust assets to satisfy the judgment, the courts then not surprisingly choose the next available remedy, which is to order the Settlor to repatriate the assets back within the jurisdiction of the court. With the exception of the Reichers case (discussed below), there are no reported cases where a court has refused a creditor's request for the repatriation remedy.

When the repatriation order is entered, the Settlor then has basically three alternatives available: comply, flee, or refuse to comply.

Comply

The Settlor can comply with the repatriation order, but of course this will probably negate the Settlor's otherwise elaborate planning. See FTC v. Fortuna Alliance (Unreported, 1997) (after issuance of arrest warrants, defendants immediately agreed to return $5 million from their Antigua offshore trust accounts); BankFirst v. Legendre (Unreported, 2002) (Settlor agreed to repatriate assets after only five days in jail);
Bank of America v. Weese, 277 B.R. 241 (D.Md. 2002) (debtor's father paid $12 million settlement to keep settlors from being incarcerated). See also J.W. v. Allvest, Inc., (Alaska Sup. 3rd Dist. No. 3AN-97-7192-CIV, 2002) (case settled favorably to plaintiffs after settlor, his FAPT, and even his attorneys were sued for civil conspiracy arising from bizarre and stupid post-judgment attempt to defraud plaintiffs).

Flee

The Settlor can flee the jurisdiction of the court. This has several serious ramifications. The court will immediately order that the Settlor be held in contempt of court, so that the Settlor's return will result in incarceration until the assets are returned. In other words, the Settlor can only flee if he never intends to return. For some debtors, such as professionals who immigrated to the U.S. from somewhere else and can always just go home, this might not be as bad as it sounds. For others, who may have significant family or ongoing business interests in the U.S., this may be an unthinkable result.

Fleeing the country will also likely trigger what is known as the "fugitive disentitlement doctrine", which means that the debtor will not be able to defend themselves in litigation or appeals if they have intentionally fled the jurisdiction of the court. This may have dramatic consequences if the creditor is able to persuade the court to enter the repatriation order early in the litigation, i.e., the Settlor will not have an opportunity to present what otherwise might be a good defense.

Refuse to Comply or Feign Compliance

The Settlor can refuse to return the assets, but this will likely result in an indefinite incarceration until the assets are returned. Although a theory briefly circulated after the Anderson case that a court could incarcerate a recalcitrant Settlor for no more than six months before of constitutional due process concerns, this theory was dispelled in the subsequent Lawrence case, where the debtor settlor has been kept in incarceration for over four years, and counting.

A variation of this third approach is that the Settlor can request a return of the assets, and then plead "impossibility" to comply with the repatriation order when the foreign trustee predictably refuses to comply. This is the approach that has been regularly advocated by the proponents of foreign asset protection trusts since the mid-1990s, and numerous professional articles have been written about the viability of the "impossibility defense".

The problem with the impossibility defense is that the courts have consistently refused to adopt it in the foreign asset protection trust context, for basically two reason: first, the courts are skeptical that there really is an impossibility and, second, at any rate the impossibility is deemed have been self-created, and the courts have routinely stated that they will not recognize a self-created impossibility. See, e.g., FTC v. Affordable Media, LLC, 179 F.3d 1228 (9th Cir. 1999) (a/k/a "Anderson case") (settlors who failed to honor repatriation order were incarcerated for 6 months); SEC v. Brennan, 230 F.3d 65 (2nd Cir. 2000) (settlor ordered to repatriate assets under penalty of contempt, but defendant was convicted of securities fraud in advance of hearing on contempt issue); SEC v. Bilzerian, 131 F. Supp. 2d 10 (D.C. 2001) (settlor held in contempt and incarcerated after refusing to honor repatriation order); In re Stephen J. Lawrence, 279 F.3d 1294 (11th Cir. 2002) (settlor incarcerated for over four years after refusing to obey repatriation order; appeal to U.S. Supreme Court failed after 11th Circuit held that he could be jailed almost indefinitely until he complied with repatriation order).

Filing Bankruptcy

The Settlor can also attempt to wash out his debts by filing for protection under the federal bankruptcy laws and assert that the assets in the foreign trust should not be included in his bankruptcy estate. This position has been consistently rejected by the bankruptcy courts that have considered the issue, and those courts have also consistently ordered Settlors to repatriate the trust assets. This then throws the Settlor right back to his original quandary of making one of the three difficult choices, but with the added disadvantage that the bankruptcy court will usually deny the Settlor his discharge, thus making the debt against him permanent until paid. See, e.g., In re Colburn, 145 B.R. 851 (Bkrpt E.D.Va. 1992) (discharge denied); Brown v. Higashi (Bkrpt Ak. 1995) (assets of Belize trust would be included in bankruptcy estate); In re Portnoy, 201 B.R. 685 (S.D.N.Y. Bkrpt. 1996) (discharge denied); In re Brooks, 217 B.R. 98 (D.Conn. Bkrpt. 1998) (stock shares held by offshore trust included in bankruptcy estate); In re Stephen J. Lawrence, 279 F.3d 1294 (11th Cir. 2002) (discharge denied and settlor incarcerated).

Although there have not yet been any cases involving the filing of criminal bankruptcy fraud charges against a settlor, it is suggested that the facts of the cases thus considered came perilously close to crossing the criminal line, and that there is a high likelihood that criminal charges may be brought in a future case. Because the filing of bankruptcy has not proven to aid settlors of FAPTs anyway, it should probably be avoided where the debtor has settled an FAPT.

The FAPT in the Divorce Setting

There are two reported cases involving FAPTs in the marital context. Riechers v. Riechers, 679 N.Y.S.2d 233 (1998), involved a physician who tried to cheat his wife (who had helped him get started in his practice) out of her portion of $4 million of their marital assets by forming (ostensibly to protect against potential medical malpractice claims) a Colorado limited partnership that was owned by a Cook Islands trust. The New York state court said that although the wife could and should purse the assets in the Cook Islands, that the $4 million was part of the divorce estate and the wife would thus be awarded $2 million satisfied by both the trust and other marital assets in the U.S.

That the New York judge did not incarcerate the physician, and instead suggested that the wife's remedy was to litigate in the Cook Islands (an endeavor unlikely to lead to success) is the one and singular reported "victory" of the FAPT against creditors. However, it is tainted by the fact that the New York judge included the assets of the FAPT in its divorce decree, thus increasing the size of the wife's judgment by $2 million that she could enforce against other of the physician's assets that she was able to locate within the U.S.

In a much more recent case, arising after the landmark Anderson and Lawrence decisions, the Wyoming Supreme Court in Breitenstine v. Breitenstine, 2003 WY 16, 62 P.3d 587 (Wyo. 2003), considered a Bahamas FAPT that the Husband attempted to use to shield marital assets from his wife. The Court allowed a marital division based on the assets in the offshore trust, commenting in a footnote that "the use of such trusts to avoid alimony, child support, and a fair division of marital property upon divorce is reprehensible to us."

In other words, the result in the divorce context will be to simply consider the FAPT's assets to be part of the marital estate, and to allow the aggrieved spouse to satisfy his or her judgment out of other domestic assets to the extent they can be found. While no case has yet considered the issue, it can be assumed that if the aggrieved spouse cannot satisfy his or her judgment from the remaining domestic property (or by alimony orders, etc.), the courts will probably next attempt to employ the repatriation/contempt relief.

Impossibility Defense Rejected in Other Contexts

All of the foregoing cases related to debtor-creditor or divorce situations. In a recent case, the courts' rejection of the impossibility defense was expanded into the tax realm. While it did not involve a self-settled spendthrift trust (but rather a trust formed exclusively for the settlor's beneficiaries), Eulich v. U.S., (N.D.Tex. Case No. 99-CV-01842, August 18, 2004), considered a Bahamas offshore trust that was created a by a U.S. Settlor who later was investigated by the IRS. When the IRS served a formal request for documents from the trust, the Settlor refused to provide the documents and claimed that he had no control over the trust and had exhausted his powers to try to get the documents. The District Court disagreed, holding that the Settlor could still attempt to get the documents from the trust by appointing new administrators and by filing a lawsuit in the Bahamas. At any rate, the Court stated, it was not going to recognize the Settlor's "impossibility defense" because the impossibility was self-created, i.e., the Settlor's own drafting caused the impossibility. The Court found the Settlor in contempt and imposed a fine of $5,000 per day on the Settlor, to be increased to $10,000 per day after 30 days, and then after 45 days the Court would consider incarcerating the Settlor until the documents appeared.

Using FAPTs Properly

Despite the promises of promoters, dozens of professional articles and hundreds of seminars preaching the benefits of FAPTs, these trusts have almost uniformly failed in their mission of protecting assets while keeping the settlors out of harm's way. Whether by incarceration, denial of their bankruptcy discharge, or adverse publicity arising from cases where the perceive that they are attempting to cheat their legitimate creditors, most of the settlors have arguably come out much worse than if they had done nothing at all.

What these failures illustrate most is that FAPTs are often used improperly, occasionally for the wrong type of clients, usually in the wrong circumstances, and sometimes too late to make this strategy even possible. But for many planners, the FAPT was the only asset protection tool they had, and so everything situation was treated by the expedient of an FAPT, whether the situation was suitable or not, recalling the old adage that "if all you have is a hammer, everything looks like a nail".

These failures also evince that too many clients and planners have believed their own propaganda and treated their untested group speculation about the "impossibility defense" with the same reverence as if it were established law. Some planners had simply drunk so much of the Cook Islands Kool-Aid that at some point it became impossible for them to conceive of an asset protection structure that did not utilize FAPTs, and their response to the cases above was to alternatively criticize them or deny the existence of their results.

But just as the prior delusions about their potential benefits reached cultish levels in the 1990s, so does the current hysteria of their purported demise have the potential to go too far. The hard truth is that FAPTs are a tool, and just one of many available in the toolbox of a good asset protection planner. FAPTs have their uses, but being an all-purpose tool for all persons in all situations is not one of them.

By contrast, the situations where FAPTs can be safely used are quite limited. The most common of those situations follows.

Non-U.S. Clients

None of the cases arising from U.S. courts should have any impact upon persons not resident in the United States. Indeed, in many other parts of the world, the use of offshore trusts is a form of planning that is respected by the local courts.

International Immigration Planning

FAPTs can play a very important role in either inbound or outbound immigration planning. It should be very difficult for a creditor to attack an FAPT that was formed prior to the settlor migrating to the United States, and probably impossible for a creditor to successfully attack an FAPT where the settlor has or intends to migrate from the U.S. prior to or upon a repatriation order being entered. Inbound examples would include the "new rich" from China seeking to move here because of greater political stability or to facilitate their import-export businesses from the United States. Outbound examples would include foreign professionals who have earned their education in the U.S. but plan to eventually return to their home country, and those who intend to retire outside the U.S., such as to retirement villages in Mexico.

U.S. Persons With Substantial and Existing International Interests

FAPTs, when used very conservatively, can be used to facilitate the interests of U.S. persons who have substantial and existing international interests, such as running businesses abroad or making sales abroad, since the trust might be justified as offering some legitimate tax or estate planning opportunities for non-U.S. source income (but not as a blatant tax dodge).

When used in this situation, the assets held by the FAPT should be limited to that earned by the non-U.S. source income, and preferably less than 50% of the clients' total net worth.

U.S. Persons as Last-Ditch Contingency Planning

FAPTs can be used for last-ditch contingency planning, within certain limits. The trouble is that historically they have been used without any limits, leading to the cases and results described above. The idea is that an FAPT may allow the settlor to ready himself should something unforeseen and extraordinary happen in the U.S. that would cause him to flee. Usually for such planning it is sufficient to merely form the FAPT and either not fund it, or fund it with a minimal amount, such as a few thousand dollars to open an offshore checking account.

The downside is that the mere formation of the FAPT is likely to trigger certain IRS tax filings, with the result that the existence of the FAPT would soon be known to creditors who might attempt to leverage that fact into implied evidence of culpability by the settlor. Thus, if litigation arises, the settlor may have to make a decision whether to maintain the FAPT (and risk the creditor using it to suggest the settlor anticipated his wrongdoing) or wind it up and voluntarily repatriate the assets. It is thus suggested that the amount in such a FAPT be kept to a relatively small amount, an in no event more than, say, 25% of the settor's total net worth. It is also suggested that if an FAPT is to be used in such a fashion, that it be one of the first asset protection structures funded so as to avoid questions about the settlor's remaining liquidity and ability to meet obligations at the time it was funded.

Why the Limitation on Funding?

If the settlor transfers the bulk of his assets to an FAPT it will trigger heightened scrutiny of the trust. This is not merely a theoretical concern, but rather it is based on common sense as well as some of the most telling language from the U.S. District Court's opinion in Lawrence that "it defies reason--it tortures reason--to accept and believe that this Debtor transferred over $7,000,000 in 1991, an amount then constituting over ninety percent of his liquid net worth, to a trust in a far away place administered by a stranger--pursuant to an Alleged Trust which purports to allow the trustee of the Alleged Trust total discretion over the administration and distribution of the trust res."
In re Lawrence, 227 B.R. 907 (S.D.Fla. 1998).

The old saying that "pigs get fact, hogs get slaughtered" applies to the funding of FAPTs. If the settlor transfers a relatively small portion of his assets to an FAPT, thus at that time leaving other assets available for creditors (even if he later takes steps to protect those other exposed assets as well), the FAPT has a much better chance of withstanding scrutiny. While the percentages that I have suggested above are arbitrarily suggested, they are what I would consider to be safe harbors all other circumstances considered.

Despite these concerns, the funding of an FAPT with all or nearly all of the settlor's wealth is pro forma practice among many asset protection planner, primarily because they have no other reliable strategies available to protect those assets. Thus we have circled back around to our previous analogy that if the only tool that you have is a hammer, everything looks like a nail. Such as it is with planners whose only tool is the FAPT.

Summary

FAPTs have usually failed to provide their promised anti-creditor benefits, and often have put their settlors into worse positions than if they had done nothing at all. But this does not mean that all FAPTs are ipso facto bad, or should be discarded as a possibly strategy in all circumstances. FAPTs can, and probably should be widely used for non-U.S. persons and those planning immigrations either to or from the U.S. Additionally, FAPTs can be used for some U.S. persons to facilitate substantial and existing international business, so long as the trust assets are limited to non-U.S. source income and not most of the settlor's net wealth. FAPTs can still be used for U.S. persons for contingency planning, but subject to substantial restrictions such as not allowing more than 25% of the settlor's net wealth to be owned by the trust.

There will be other situations where FAPTs may be used, within the limitations appropriate to those circumstances. As discussed, FAPTs are simply a tool, and one that should neither used indiscriminately nor completely discarded. For most asset protection planning for U.S. persons not intending to immigrate or not having substantial and existing international businesses, FAPTs probably should not be used, and at any rate there are much better, safer, and proven domestic alternatives available.