Delaware Asset Protection Trusts and Creditors' Rights

Settlor-benef ic iaries who create Delaware asset protection trusts will have greater protection against the claims of bankruptcy and non-bankruptcy creditors than they otherwise would have had if they had not created such trusts.

TOOO A. FLUBACHER ANO RANDOLPH K. HERNDO N. JR .• ATIOR NE YS

ruSt settlors have had the abil­ addressed is what happens when (A) that restricts or condi tions trans­ ity to create a Delaware asset a creditor tries to access assets held fer of such interest by the debtor.... " protection trust (DAPT) since in a DAPT in the context of the set­ However, section 541(c)(2) provides T1997 under the Delaware tlor's bankruptcy. an exception to this rule for an inter­ Qualified Dispositions in Trust Act, est in a truSt that is subject to a valid 12 Del. C. SS 3570 et al. (the Bankruptcy protection 01 spendthrift provision. Bankruptcy ... Act"). Under traditional common benelielallAterests In aDAPT Code section 541(c)(2) states "[aJ law, a spendthrift clause included Ban kruptcy Code section 541(a)(1) restriction on the transfer of a ben­ in a trust instrument is inapplica­ provides that a debtor's bankrupt­ eficial interest of the debtor in a trust ble to the settlor-beneficiary of a cy estate includes "all legal or equi­ that is enforceable under applicable sel f-settled trust and the settlor's table interests of the debtor in prop­ nonbankruptcy law is enforceable creditors could obtain access to the erty as of the commencement of the in a case under this title." assets of a self-settled trUSt.1 How­ case .... " This provision has been DAPT is essentially a trUSt that ever, the Act is a statutory override interpreted very broadly. The contains a spendthrift provision of this traditional common law breadth of section 541 (a) has been that applies to the settlor pursuant rule. If a trust qualifies as aDAPT expanded by section 541 (c)( 1 )(A), to the Act. A spendthrift provision under the Act, then its spendthrift which states that "an interest of the is a provision in a trust instru­ clause may apply to the settlor. debtor in property becomes prop­ ment that generall y prohibits or A discussion of the requi rements erty of tl ~e [bankruptcy] estate ... invalidates the voluntary or invol­ for a trust to satis fy the p rovi­ notwithstanding any provision in untary assignment, pledging, trans­ sions of the Act , a nd thus become an agreement, transfer instrument, fer, or anticipation of the benefi­ a valid DAPT, has been addressed or applicable non bankruptcy law- ciary's interest in the trust. by numerous authors and is out­ By the express terms of section side of the scope of this article. This TODD A. FLUBACHER Is a partner and RANDOLPH 3570( I I)c of the Act, the spendthrift K. HERNDON, JR .. is an associate with the Trusts, article is intended to discuss the EstatesandTax Group of Morris, Nichols,Arsht& Tun· provision of a DAPT instrument is rights that creditors may have to nell, LLP in Wilm ington, Delaware. Mr. Flubacher is a restrictio n on the settlor's benefi­ access the assets of a DAPT once it also a fell ow 01 the American Col lege 01 Trust and cial interest that is enforceable under is created. The first issue to be Estate Counsel. applicable non bankruptcy laws -19 20

within the meaning of Bankruptcy become property of the bank­ have generally held that distribu­ Code section 541 [c)(2).2 Although ruptcy estate and may be distrib­ tions from a trust arc includable in a cred itor may contend that the uted among the creditors of the the bankruptcy estate under sec­ "applicable non bankruptcy law" debtor-beneficiary.5 Thus, in the tion 541 (a)(5)(A), which states that uncler section S4 1{c)( 2 ) is the law absence of a spendthrift provision, t he bankruptcy estate includes: of the debtor's domicile, which may a de btor-beneficiary's r ight to " [a]ny interest in property that nor have adopted self-settled asset receive income, annuity, or uni­ would have been property of the protec tion trust legislation, this trUSt distributions over a period estate if such interest had been an a rgument should be unsuccessful of time, or for the remainder of his interest of the debtor on the date with respect to a properly structured or her lifetime, will become a part of the filing of the petition, and th at and administered DAPT.3 of the bankruptcy estate and, in the debtor acqui res or becomes the future, the debtor-beneficiary entitled to acquire within 180 days Discretionary trusts. If a settlor­ w ill no lo nger possess that inter­ after such date-(A) by bequest, benefi ciary has the right to receive est. 1 However, numerous cases dev ise, or inheritance .... "1 distributions of income or principal have held that under Bankruptcy The Bankruptcy Code does not in the sole discretion of the trustee Code section 541(c)(2), a debtor­ define the terms, "bequest," from a trUSt that is not a DAPT (or beneficiary'S interest in a trust that "devise," or "inheritance." None­ an asset protection trust uncler a law is subject to a valid spendthrift theless, courts have held that a similar to the Act), the entire [rust provision under applicable state distribution of income received by fund may be subj ect to the claims of law is not a part of the bankrupt­ a benefici ary from a testamentary the settlor's creditorS. 4 If the trust is cyestate.7 trust with a spendthrift clause is a a DAPT, however, then generall y the " bequest, dev ise, or inheritance" entire trust fund should be pro­ .Inkrl ptcy protlCtl.n within the meaning of section tected from the settlor's creditors. lor DAPT distributions 541(a)( 5)(A).1 However, a majori­ O nly distributions actually made to Although a debtor-beneficiary's ty of courts have not held t he the settlor would potentially be sub­ income, annuity, or unitrust inter­ same for inter vivos trusts with a ject to the settlor's creditors. est in a DAPT, as well as the remain­ spendthrift clause. Although at least der interest of the trust, should not one court has expanded sC<,.ction Income, unitrust, or a'lnuity be includable in the bankruptcy 541 (a)(5)(A)'s reach beyond testa­ trusts. If a debtor in bankruptcy eState, the distributions from the mentary trusts, 1I1 most courts have is a beneficiary of.a trust, and there trust to the debtor-beneficiary will declined to extend this principal is no spendthrift clause applicable be included as a part of the debtor's to apply to such inter vivos trusts.11 to the debtor-beneficiary's inter­ bankruptcy estate to the extent that We are not awa re of any bank­ est, or there is a spendthrift clause the distributed assets fall within the ruptcy cases involving income, annu­ but it is not valid, the debtor-ben­ scope of Bankruptcy Code section ity, or unitrust distributions received eficiary's interest in the trust will 541(a ). In such cases, the courts by a settlor of an asset protection

1 See Restatemen/ (Second) of Trusts. se<:lion I See, e.g .• In fe Mack, 269 B.A. 392 (Bkrplcy. excluding the trust assets from the bankrupt­ 156(1) (1959); Weymouth v. Delaware Trust Minn. • 200 1). The court In that case slated that cy estate."); see also Pallarson v. Shumate. Co., 45 A.2d 427 (Del. Ch., 1946); Wilmington all 01 the debtor-beneficlar{ s inlerests in th e 504 U.S. 753 ( 1992) (extending Ihe reach 01 Tru st Co. v. Ca rpenler. 75 A.2d 815 (Del. Ch., trust. including the power 10 remove and 541 {c)(2) to exclude a debto(s interest In an 1950). appoln! trustees. became tha properly of the ERI SA·qualilied plen), 1120eI.C. §3570(1 1}c. bankruptcy estate. I 11 U.S.C. section 541(a)(5)(A). I See Scott and f ratcher, The Law of Trusts. § I If the deblor only pl)Sl>8sses the right 10 receive I See. eg., In re Kragness, 58 B R. 939 (Bkrpt­ Income. annuity. or unitrus! distributions, the 626(3) (4th ed., 1989) ("What then is the law cy. Ore., 1986): In re Hunler. 261 B.A. 189 remainder Interes! ollhe trust should not applicable in detarminlng whether a benefi" (Bkrptcy. DC Fla •. 20(1); In the Mal1er of Hec::hl , become a pari of the bankruptcy estate. Ciary·s inlerest Is transferable or can be 54 B.R. al 383 ("Once Income is received by reached by his creditors [in bankruptcy]? 1 See. e.g .• In the Malter of Moody. 837 f.2d 719 lhe b8fleficiary or the beneliciary is entilted to We have seen th at ordinarily the law of the (CA·S. 1988): In the Mener 01 Hecht 54 B.R. receive 11 under Ihe terms of Ihe trust, the slale ollhe piece 01 administration ... deter· 379 (Bkrptcy. DC N.Y. • 1985): Maner of New­ Income is no longer entitled to spendth rift pro­ mine s whether the Interest of a beneliciary is man. 903 f .2d 11 50 (CA·7, 1990)("While there tection."). 8$s illnable to him and whether it can be Is disagreement about what else It might cover, reached by his credi tors. Hence it is the lew It is clear that the phrase 'applicable non­ 10 See, e.g ., In the Maller of Moody, supra of that state which determines whether it can bankruptcy law' used In [seclion 541 (c)(2)] flO\e 7 ("SUCh Irust Income payments would be reached by his truslee In bankruptcy." ): see was intell(\ed to be applied to sta te law con­ qualify as ·beQuests· under 11 U.S C . also In re Hunter. 380 B.R. 753 (Bkrptcy. DC cernll\g spendthrifltrustS .... "): In re Coumbe. § 541(a)(S)(A)."). The courl did 001 make clear OI'Iio. 20(8) ("In decidil\g whethef a debto(s 304 B.R. 318 (CA-9 BAP.. 20(3) ("Under § whether the trust et lssoo was created as an Interest is an inte,est in a trus!. courlS took 10 54 l(c)(2). an anti-alienatiOn provision in a valid inter vivos truSt or as a testamentary trust. How­ the law governing the purporte

E.9T Al E P L A N NIN G SEP T E "' BE~ 20'0 VO~ 31 I NO 8 21 truSt. Consequently, it is not d ear distributed during the 180-day peri­ interpretation of any of these pro­ whether income distributions to the od foll owing the filing to a bene­ visions would allow only income dis­ settlor of a DAPT would be incl ud­ ficiary who was not the settlor of tributions received by the debtor­ able in the bankruptcy estate under an inter vivos trust.12 Additional­ beneficiary within 180 days after the section 541(a)(5)(AJ as a " bequest, ly, a debtor could argue that sec­ commencement of the proceeding to devise, 01' inheritance" o r whether tion 541(a)(1 ) specifica ll y di rects be includable, Income received by such payments would be includable th e reader to section 5 41 (c)(2) the debtor-beneficiary after the 180- under some other provision of sec­ which, as discussed above, supports day period following the filing of the tion 541(a). DAPTs, however, are enforcing a restriction on the trans­ bankruptcy petition would no t be inter vivos truStS and do nOt clear­ fer of a beneficial interest if such included in the bankruptcy estate. ly fall within t he mea ni ng of a interest would be enforceable under " bequest, devise, or inheritance." a pplicable non bankruptcy law. fraudulent conveyaAclI t. aDAPT Additionall y, such income distribu­ The Bankruptcy Code also includes tions to the settlor of a DAPT may a fra udulent conveyance provision nOt be incl ud able unde r sect ion that is specifically directed at self­ 541 (a){5)(A) because the senior was settled trusts. Bankruptcy Code sec­ the original transferor of rh e assets. A DAPT is tion 548(a) provides that a trustee Another provision of section essentially a in bankruptcy can avoid any trans­ trust that contains 541 (a), which creditors may cite to a spendthrift fer that was made or incurred with­ include income distributed to the provision that in two years before the filing of the senior of a DAPT in the bankruptcy applies to the bankruptcy petition if there was es tate, would be section 54'1( a)(1 ). settlor pursuant an actual intent to hinder:, delay, or It includes "all legal or eq ui table to the Act. defraud. The Bankruptcy Abuse Pre­ interests of the debtor in properry ventio n and Consumer Protection T h us, to be includable in the as of the commencement of the Act of 2005 (the 2005 Act) added bankruptcy estate, a distribution case" (emphasis added). Under this a new section 548(e), which extends from a DAPT must ei th er: provision, only the income distri­ the two-year period to ten years for butions that the settlor received, or 1. Have been received by the sett­ self-settled trusts if the transfer to was entitled to receive, up to the lOr/beneficiary prio r to the fi l­ the trust was a fraudulent transfer. time of the commencement of the ing under secei on 541 (a)(1 ). Implicitly, sectio n 548(e) validates bank ruptcy proceeding would be "2. Be received by the debtor-bene­ the legitimacy of a DAPT, includable in the bankruptcy estate, ficiary within 180 days fol1ow­ The background to the enact­ and any distributions made after ing the filing of the bankruptcy ment of Bankruptcy Code section t he commencement of the pro­ petition and result from a 548(e), as a part of the 2005 Act, ceeding (including distributions bequest, devise, or inheritance is both interesting a nd relevant to made within 180 days fo ll owing under section 541(a)(5 )( A). the d iscussion of the acceptability the commencement of the pro­ Regardless of which provision of DAPT's. Reportedly in response ceed ing) would not be includable. under section 541 (a) may cause the to a New York Times article criti­ For example, at least one court income distributions of a DAPT to c izi ng domestic asset protection has speci fi call y declined to use sec­ be includable in the bankruptcy truStS, a Se na tor Cha rles Sc humer tion 541(a)(1 ) to include income estate, it appears that the broadest of New York proposed an amend-

11 See. e.g .• MaHer of Newmal1, 903 F.2d at 1154 In re Schmitt, 215 8.R. 417 (CA·9 BAP.. 1997) 2004) ("[TJhis Court must , conclude that ("Congress listed the specific Interests to be (staling thaI inter vivos trusts are not consid­ section 541 (a)(5) does not operate to Include Included as property of the Ibankruptcy] ered an intere st obtained by "bequest, devise, interest In property transferred to a debtor estate. Those interests do not include a cat­ or inheritance. ") ; In re Crandall, 173 B.R. 836, by way 01 inter vivos trust. "): In re Eley, 33 1 egory Into which an inter vivos spendthrift tlUst 839 (Bkrptcy. DC Conn., t994) (·The court is B.A. 353 (Bkrptcy, DC Ohio, 2005) ("§ may lil. •.. The decisionol Congress to Ilslcar­ constrained to give a narrow construction to 541(a}(5}(A) does not allow postpelition dis­ taln Interests without introducing them with the the words 'bequest, devise , and inheritance' tributions from an Ohio inter vivos spendthllft words 'includes' or 'includll"lg' creales a pre­ and to conclude such words In their plain thrust to become property of the beneficiary's sumptiOn that those are the sole InterMls COY· meaning do not enCOmpaSS ... inter vivos bankruptcy estate.·). ered •••• ISuchl [playments (do not] qualify Irusts.-); In re Roth , 289 B,R, 161 (Bluptcy. DC 12 See Newman, 903 F.2d at 1154 ("Payments as Interests ' by bequest, devise, or Inheri· Kan .• 2003) (-(Tlhis Court cannot simply made to the debtor Irom the trusts during the tance,' as specified in 11 U.S.C. § 541(a)(5)."); assume that Congress intended to include ISO days fol lowing the filing 01 the bankrupt­ In re Coombe, 304 B.R. at 385 (distinguishing every vehicle for uanslerrlng properly upon cy aclion are not inlerests held by the debtor Newman on the basis that the income dlstri" death in § 541(a)(5), since it clearly under­ at the commancement of the case, as spec;" bution In Coumbe derived Irom a testaman· slood the concept 01 trusls 11"1 passing other lied in It U.S.C. § 54 1(a)(1 ). ...• ). tary tru st, where, In Newman, the income federal statutes in the same time !rame." ); In 13 See MOfgenson, "Proposed Law On Bank" distributions came lrom an Inter vivos aus!): re Spencer, 306 B.R. 328 (Bkrptey. DC Calif.. ruptcy Has loophola: N.Y, TImes, 31212005.

SEPTE"'BER 2010 VOL 37 I NO iii "SSET PROTECTIO N TRUS T S 22 - menr to the 2005 Act legislation to is very important background The first case, In re Potter,'· is puB all assets over $125,000 trans­ because it makes clear that Con­ an un reported case from the Bank­ ferred to a self-settled trust in to the gress has expressly debated and ruptcy Court in the District of New bankruptcy estate. considered the efficacy of domes­ Mexico that found that section The article asserted t hat the tic asset protection trusts and essen­ 548(e) applied to transfers that a bankruptcy legislation then being tially approved of the use of asset debtor made to a se lf-settled truSt debated in the Senate, which was protection trusts by a vote of 73 to governed by California law. It is intended to make it harder for peo­ 26 in adopting th is 2005 amend­ important to note that California ple to walk away from credit card ment to the Bankruptcy Code. does not authorize self-settled asset and other debts, is insufficient protection trusts. Rather, this court, because it fa ils to close "an increas­ under applicable California law, ingly popular loophole that lets noted that "when the settlor is a wealthy people protect substantial Congress has beneficiary of the trust, any spend­ assets from creditors even after fi l­ expressly debated thrift provisions are invalid." Thus, ing for bankruptcy." The loophole and considered the spendthrift provision of the the efficacy of that the article criticized is the use domestic asset trust was unenforceable with of domestic asset protection trusts. protection trusts respect to the settlor and the bank­ The article cast a negative light and essentially ruptcy trustee could reach the assets o n asset protection trusts and star­ approved of the of the trust. This would a lso be the ed that such trusts should either be use of asset result in Delaware for self-settled protection trusts. excluded from the bankruptcy law, trusts that do nOt comply with the which exempts assets held in trust Under section 548(e), a trustee requirements of the Act. that are governed by "applicable in bankruptcy "may avoid any Nevertheless, the Potter court nonbankruptcy law" under Bank­ transfer of an interest of the debtor examined section 548(e) as a means ruptcy Code section 541(c)(2), or in property that was made on o r for creditors to reach the self-set­ a dollar limit should be placed on wi thin ten years before the date tled assets of the trust. In the case, the assets that may be used to fund of the filing of the petition if­ the debtor admitted to having a a n asset protect ion trust. The arti­ (A) such transfer was made to a self­ $600,000 judgment against him at cle stated t hat such trusts have settled trust or similar device; the time he created, and transferred become "increasingly popular in (8 ) such transfer was by the debtor; properry to, the self-settled trust. recent years among physicians, who (C) the debtor is a beneficiary of T he court found that the stated fear large medical malpractice such trust or similar device; and purpose of the trust was "to pro­ awards, and corporate executives, (D) the debtor made such transfer vide for the maintenance of Mr. whose assets are at greater peril with actual intent to hinder, delay, Potter and fund his litigation, thus now because of new laws." Accord­ or defraud any entity to which the its intended effect could only be to ing to the author, wealthy indi­ debtOr was or became, on or after shield his assets from creditors in vi d uals can use asset protection the date that such transfer was order to allow Mr. Potter addi­ trusts established in states like made, indebted." tional ti me to pursue and defend Delaware to shield their assets from The effect of section 548(e) on pending litigation." creditors, ca ll ing such trusts an a sett lor-beneficiary of a DAPT is The court held that the trans­ "abuse by rich people." not fully apparent. Since the enact­ fers to the trust , "as analyzed The proposed legislative change ment of the 2005 Act, we are aware (under the state Uniform Fraudu­ would have had a significantly dele­ of only twO Bankruptcy Court cases lent Transfer Act [U FTA]) ... were terious effect on se lf-serried asset that have ana lyzed section 548(e). made with the intent to hinder or protection trusts in the bankrupt­ Despite the apparent legislative de lay,» and thus the trustee in cy context. Senator Schumer's pro­ intent that section 548(e) should bankruptcy could establish a claim posed a mendment was defeated apply to self-serried asset protec­ under section S48(e). Although the in the Senate by a vote of 56 to tion trusts that include a valid court found that actual intent to 39. Subsequently, SenatOr J im Tal­ spendthrift clause a pplicable to the defraud may be inferred under the ent of Missouri proposed an settlor and provide the settlor with UFTA from the facts a nd circum­ amendment that is currently found creditor prNection, the two cases stances in the case, the court also in Bankruptcy Code section 548(e). that we have identified do not even ,. 2008 WL 5157877 (Bkrptcy. DC N.M .. It passed by a vote of 73 to 26. This involve such truS[$. 7{29/2008).

EST ",TE PL ANN I N G SEPTEMSER 20 1 0 VOL 37 I N O" 23 noted that since the UITA requires to establish a spendthrift trust on bankruptcy judge from t he Dis­ - an "intent to hinder, delay, or the birth of his children. The debtor trict of Utah authored an article sug­ defraud, it is sufficient if the facts funded the trusts over a period of gesting that a trustee in bankrupt­ and circumstances show that the time with cash and life insurance cy, to avoid a transfer under section defendant me rely intended to hi n­ policies. The bankruptcy trustee 548(e), need not provc that a sett­ der o r delay hi s or he r credi tors." asserted that rhe assets of the trusts lor intended such transfer to defraud O ne other important nOle from were subject to the ten-year look­ a creditor, although that proof Potter was that the court fo und that back provisions of section 54S(e). would be sufficient. Rather, Judge a debtor need nor be the sole ben­ In a summary judgment motion, the Glen Clark ind icated that a trustee eficiary of the self-scaled (fust for debtor argued that the bankrupt­ in bankruptcy might need to prove section S48(e) to be applicable. The cy trustee had no section 548(e) only that the debtor intended to hin­ debtor had a rgued that the t rust claim because the trusts were not der, or delay, future creditors as part was not se lf-se ttled because there self-settled trusts and the debtor is of an asset protectio n strategy. IS were beneficiaries other than the not the beneficiary of the trust. In contrast, the Act requires, for debtor and because some of the T he court found the debtor's a creditor whose claim arose after transfers to the trUSt were made arguments " unpersuasive" and that a transfer to a DA PT, proof that th e from two limited liability compa­ section 548(e) "allows avoidance transfer was made with an actual nies. The trust " was funded in part of transfers made to a self-settled intent to defraud such cred itor.ll with shares of Summit Investment trust or similar device . .. (Emphasis Consequently, such transfer could and Summit Valdes, two inde­ added.) The bankruptcy trustee no t be avoided in a Delaware state argued that the truStS were "simi­ pendent li mited liability compa­ court acti on if the creditors could lar devices" and that the debtor was nies. [However, the debtor was] the prove o nly that the settl or actual­ actually the trust beneficiary of the sole member of Summit Investment, ly intended to hinder or delay a trusts. The court found that there and Summit Investment, in turn, creditor whose claim arose after were genuine issues of material fact, own~d a ll th e membership interest such transfer. Therefo re, under this which precluded summary judg­ of Summit Va ldes." view, section 548(e) would sub­ ment. Ultimately, when these issues The court dismi ssed this claim, stantively extend the abili ty of a were decided by the Kansas Bank­ however, holdi ng that fo r secti on trustee in bankruptcy to avoid a ruptcy Coun in April 200S, the 54S(e) to a pply, " the debtor need transfer made to a DAPT. court held that t he trusts were only to be ' a' beneficiary, not the A moderate interpretation notes deemed to be the debtor's "' nomi­ sole beneficiary" of the trust. that because asset protection trust nees" ano the assets of the rrusts The second case from the Bank­ statutes already do not provide pro­ were t reated as the assets of the ruptcy Court for the Distr ict of tection against fraudulent transfers, Kansas, In re Krause,'5 involved sev­ debtor himself, due to a substantial factual record of th e debtor using scction 54 S(c) simply appears to e ral irrevocable trusts that the extend the four-year limitation peri­ debtor created for the benefit of rhe and controll ing the trusts for him­ od, as provided for under the UITA, debtor's chi ldren, and the debtor self and engaging in a decades-long to a period of tcn years. I S Delaware did not retain a beneficial interest. "scheme" of keeping assets out of has adopted the UITA, whose def­ In o ther words, these trusts were his own name, while using them for inition of fraudulent transfers is sub­ neither asset protection trusts nor his personal benefit a nd avoiding stantially identical to the language self-settled. Prior to marriage, the creditors. The iss ues involving the used in section 54S(e).le Delaware's debtor entered into an a ntenuptial trusts were not ultimately decided adoption of the UITA is specifical­ agreement that required the debtor under section 54S(e), and the rele­ vance of the Kansas court's analy­ ly referenced in thc Act.20 Thus, pur­ 11 386 B.A. 785 (2008). sis of the section is q uestionable in suant to this analysis, section 54S(e) " See Clark, "Bankruptcy Muscle on Steroids­ light of the facts a nd the ultimate would not substantively expand the Ne w Changes to Chapter 5 of the Code: 012606ABl·CLE 350 (2005). disposition of the case. potential means of transfer avoid ­ 11 See 12 Del. C. § 3572(a). It is still not clear how section ance that currently exist under the I. See ShaUel end Bundy, -Impact of New Bank· ruptcy Plovn.ion on Domestic AssaI Protec· 548(e) will be interpreted when a Act. Rather, it only broadens the pro­ tion Trusls.- 32 ETPL 28 (July 20(5). set of facts may present a closer call. cedural w indow through which a " See 6 Del. C. § § 1301·11. For a definition of fraudulent transfers under the Delaware Uni­ At least three variations exist as to trustee in bankruptcy may avoid IOfm Fraudulent Tra nsfer Act. see 6 Del. C. § such a transfcr by extending the four­ 1304(a)(I). implications of this sratute. As one zo See 12 Del. C. § 3572{b)(2). in itial interpretation, a Un ited States year limitations period to ten years.

SEPfEMeER 2010 VOL 31' NO 0 ASSET PROTECTION TRUSTS 24 - Another interpretati on put for­ General judgment creditors over the trustee. Under the prevail­ ward in a co-authored article by a Outside of the context of a bank­ ing test, the creditor must satisfy twO United States bankruptcy judge from ruptcy proceeding, the extent to conditions: the Western Di strict of Tennessee which a cr ed itor could attack 1. That the trustee maintai ns cer­ would be even more favorable to a income, annu ity, or unitrust dis­ tain minimum contacts with settlor. J udge William Brown ana­ tributions from an asset protection the forum state. lyzed section 548(e) as to require trust in a state court proceeding is 2. T hat asserting personal juris­ that a trustee in bankru ptcy prove unclear. It may be p ossible for a diction would not offend tradi­ not just that the settlor intended to credito r who o btains a favorable tional notions of fair play and hinder, delay, or defraud creditors judgment to have a judgment lien substantial justice.24 in general when making the trans­ issued aga inst the debtor's bank fer, but rather the settlor intended a ccounts or employ some other If the settlor uses only a Delaware to hinder, delay, or defraud a spe­ means of obtaining assets distrib­ trustee who maintains no office in cific cred itor at the time of the trans­ uted from a DAPT following th e the fo rum state and sends no repre­ fer. 21 A similar analysis was a lso judgment. A creditor might also try sentatives there, ir is possible rhat a offered by Judge Clark as an alter­ to obtain a judgment against the courr will not be able to assert per­ native to the first interpretation.22 settlor in a state that does no t rec­ sonal jurisdiction. 25 There are also Under either of these latter two imer~ ognize self-settled asset protection arguments tha't the issue of juris­ precarions, as long as at the rime of trUStS and then come to Delaware diction over the trustee of the DAPT the initial transfer into a DAPT the and argue that such judgment is must be viewed from nor the per­ settlor is solvent and does not make enforceable against the DAPT under spective of the trustee's contacts with such transfer to defraud creditors, the Full Fa ith and C redit Clause the other jurisdiction in its corpo­ then such settlor would be able to of the U.S . Constitution. Many arti­ rate capacity, but rather whether the defend successfully against any cles have been w ri tten about the court has jurisdiction over the potential section 548(e) fra udu­ Full Faith and Credit Clause in this trustee, in its capacity as trustee of lent transfer claims. context, and a complete discussion this particular trust.2t of the Constitutional issues is o ut­ In the event that a creditor suc­ side the scope of this article. We cessfull y argues that the tru st e~ was note, however, that there are sev­ subject to personal juri sdiction in a The existence eral important issues to be forum state, the court must decide of a DAPT presents addressed here. a substantial whether to apply Delaware law or First, a court in another state must impediment to the law of the forum state. In deter­ have jurisdiction, either in the form a creditor. mining which state's law governs the of in rem jurisdiction over the trust va lidity of a trust, a Delaware court The important point to be made property or personal jurisdiction considers the following factors: a bo ut Bankruptcy Cod e section over the trustee. If a trustee holds 5 48(e) is that it a ppears to estab­ and administers all trust assets exclu­ 1. T he intention o f the settlor of lish clearly that a creditor should not sively in Delaware, the trustee could the trust. have the ability to pull the corpus of argue that another state would not 2. T he domicile of the trustee of a properly created DAPT into the have in rem jurisdiction over the trust the trust. debtor's bankruptcy estate, because corpUS. 23 T hus, the creditor may be 3. T he place where the trust is section 54 8(e) requires the presence forced to seek personal jurisdiction administered.21 of a fraudulent transfer. A transfer to a DAPT should never be a fraud­ 21 See Brown, Bankruptcy and Domasric Ra/a­ assert personal jurisdiction over the trustee rions Manua/§ 11:3. only il the trustee had · purposefully avail(e d] ulent transfer, and practitioners and 2l See Clark. supra note 16. Itself of the privilege of conducting activities within the fo rum State.- Because the tr us tee fid uciaries should (and do) take great 23 See Walke r v. W. Michigan Nat. Bank'"' Trust, 324 F. Supp. 2d 529 (DC Del.. 2004). a'f"d 145 had no contact with Florida. the courl could care to ensure that transfers to a Fed. Appx. 718 (C A-3, 2005). not establish personal jurisdiction. DAPT are not fraudulent transfers. •• See Intemational Shoe Co. v. Washington. 326 21 See. e.g .. Perrine v. Pennroad Co rp .. 168 A. 196 (Del. Ch. 1933). A fraudulent transfer can be defeat­ U.S. 310 (1945). 25 See Hanson v. Denckla . 357 U.S. 235(1958). .1 See LewiS v. Ha nson. 128 A2d 819 (Del., ed under both the Act and the Bank­ Hanson involved a Delaware trust created 1957), aff"d sub nom. Hanson v. Denckla, 357 by a Pennsylvania senior who exercised a life­ U.S. 235. relt 'g den. 358 U.S. 858 ( 1958): ruptcy Code, and it goes without say­ time power of appointment and died in Flori­ see also Wi lmington Trust Co. v. Wilmington ing that counsel should never assist da. Although the Florida court ruled on the Trust Co .. 24 A.2d 309 (Del .. 1942): Wilming­ validity of the seWor'S exercise 01 such power. ton Trust Co. v. Sloane. 54 A.2d 544 (Del. Ch., a client with a fraudulent transfer. the Supreme Court held that the Florida court 1947).

ESTATE PL ANN I N G SEPTEMeER 20'0 VOL a1 I NO II 25 ------~..~ -- T his is generally consistent with From a practical standpoint, a retains the right to receive income, traditional common law trust con­ creditor would likely first seek unitrust, or annuity distributions will flicts of laws analysis in most juris­ recovery from the debtor by look­ be better off creating the trUSt as a dictions. ing to assets other than the debtor's DAPTthan as a trust in anomer juris­ If the DAPT is properly struc­ beneficial interest in a DAPT. The diction that does not provide credi­ tured and administered, the choice existence of a DAPT presents a sub­ tor protection to a settlor. of Delaware law should satisfy the stantial impediment to a creditor conflicts of laws rules in Delaware and hurdles that a creditor will like­ • In the best-case scenario, as well as the other jurisdiction, Iy prefer to avoid. The jurisdictional (1) the assets of the DAPT and Delaware law (including the and choice of law issues are com­ wi ll be protected from the set­ Act) should apply to t he DAPT plicated, and trust law issues will tlor's creditors, (2) the senior's (although there could potentia ll y probably be unfa mil ia r to a plain­ income, annuity, or unitr ust be an issue if the application of tiff's lawyer seeking recovery for . interest will not be assignable Delaware law violates strong pub­ a creditor. Under the Act, if aDAPT and cannot be anticipated, and lic policy of the state that has the is defeated under the Act because (3) creditors can only make a most significant relationship to the the transfer of assets to the DA PT cla im against actual distribu­ matter at issue}.28 was a fraudulent transfer, the DAPT tions made prior to the filing If a non-Delaware state court would be defeated only to the of the bankruptcy petition. applied the law of a state other than extent necessary to pay that cred­ • In the event of bankruptcy, Delaware, the Ac t creates an addi­ ito r's claim, together with such it is possible, but unlikely, tional hurdle by providing that the costs, including attorneys' fees, as that income, unitrust, or 31 trustee of a DA PT will cease to the court may a llow. annuity payments made wi thin act as trustee in all respects and that The trustee of a DAPT may use 180 days after fil ing would a successor trustee must be appoint­ trust assets to pay its costs of liti­ be included in the bankruptcy ed.29 f'.lternatively, the trustee could gating the claim before satisfying the estate, and it appears that the bring an action in Delaware court claim. Under section 3574(b)(1)(a) corpus of a DAPT would be to obtain a competing order hold ­ of the Act, unless a creditor proves ing that Delaware law applies. This by clear and convincing evidence that pulled into the bankruptcy was the conflict between the Flori­ a trustee acted in bad faith in accept­ estate only if the debtor made a da and Del aware courts in the sem­ ing and administering the trust, the fraudulent transfer w ithin the inal Delaware case, Lewis v. Han­ trustee has a first and paramount lien previous ten years under Ba nk­ son,30 wh ich ended u p bei ng aga ins t the assets of the DAPT in ruptcy Code section 548(e). decided by the U.S. Supreme Court. an amount equal to the entire cost, • In the worst-case scenario, if Finally, even if the fo rum state court including attorneys' fees, properly the DAPT is invalidated, the d id assert personal jurisdiction and incurred by the trustee in the defense senior has created a situation ruled t hat, under the law of the of the aC[ion or proceedings to avoid in which many legal hurdles forum sta te, the p roperty in t he the qualified disposition.32 It is pre­ (and lengthy judicial proceed­ DAPT could be used to satisfy the sumed that such trustee did not act ings) lie between the creditor judgment, the creditor still would in bad faith merely by accepting such and the assets of the DAPT, need to persuade a Delaware court property.33 If a benefic iary has making the assets of the trust to enforce the out-of-state judg­ received distributions from a DAPT an unattractive target. If the ment. Overall, these hurd les create prior co the date the creditor com­ assets of a DAPT were targeted significant disincentives for a cred­ menced the action, the beneficiary by a creditor, the trustee would itor to pursue property that is trans­ may keep the distri bution unless defend the va lidity of the trust ferred to a D A PT. the creditor proves by clear and con­ in li tigation, paying attorney's vincing evidence (or by a prepon­ 21 See Restatement (Second ) of Conflict 01La ws fees and other costs of defense §270(197 1). derance of evidence if the benefici­ as proper charges against the 29 See 12 Del. C. § 3572(g). ary is the transferor) that he or she 30 l ewiS Y. Hanson, 128 A.2d 619 (Del .. 1957). acted in bad faith."'" trust assets, resulting in the aff'd sub nom. Hanson Y. Denckla. 357 U.S. 235, rah'y den. 358 U.S. 858 (1958). creditor's ultimate recovery 31 See 12 De l. C. § 3574{ a) . Conclusion from such litigation to be 32 See 12 De l. C. § 3574(b )( l)a. worth only a fraction of the 3S See 12 Del. C. § 3574( b )( 1 )e. It seems that in all events, a senior "'" See 12 Del. C. § 3574( c). who creates a trust in which he or she total trust fund . •

SEPTEMBER 2010 VOL 37 I NO 9 ASSE T PROTECT I ON TRUSTS