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Self-settled Spendthrift Trusts Move Close to Home

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Self-settled spendthrift trusts have gained enormous popularity as an asset-protection tool.2 In the past, most asset-protection schemes required the use of foreign trust law. However, Delaware3 and Alaska4 recently enacted legislation that enforces self-settled spendthrift trusts against creditors. As a result of this legislation, panel trustees and creditors will face the challenge of reaching assets in these trusts when a debtor enters bankruptcy.

Delaware and Alaska provide only limited relief for certain creditors and panel trustees. The trust may be attacked as improperly established if the debtor made a procedural error in establishing the trust. In addition, a panel trustee or creditor may bring a fraudulent conveyance action if the statute of limitations thereon has not expired, and limited groups of creditors may reach a debtor's trust.5 Aside from these limited exceptions, the best strategy for a creditor or panel trustee facing a self-settled trust is to argue that the corpus of the trust is property of the bankruptcy estate under §541(a).

Upon the commencement of a bankruptcy case, the debtor's entire interest, whether legal or equitable, in any property wherever located, becomes part of his bankruptcy estate.6 The estate does not include a debtor's beneficial interest in a trust if the trust is subject to a restriction on the debtor's interest that is enforceable under "applicable non-bankruptcy law."7 Delaware provides that a restriction on transfers in a Delaware trust instrument is a restriction "that is enforceable under applicable non-bankruptcy law within the meaning of §541(c)(2) of the Bankruptcy Code."8 Although Alaska's statute is silent on the matter, application of Alaskan law would likely yield the same result. Section 541(c)(2), however, requires that applicable non-bankruptcy law enforce the restriction on transfers; it does not specify that Delaware or Alaska law governs the enforceability of the restriction. Consequently, courts will have to determine which "applicable non-bankruptcy law" determines the validity of the transfer restriction.

Most courts resolve conflict-of-law issues in bankruptcy using the Restatement (Second) Conflict of Laws.9 The "most-significant-relationship" test is the touchstone of this analysis. The Restatement provides that the law the settlor designates in the trust instrument determines the validity of the trust only if the designated state has a "substantial relation" to the trust.10 Moreover, this designation yields if the designated law violates "a strong public policy of the state with which, as to the matter at issue, the trust has its most significant relationship."11

Courts have applied the "most significant relationship" test to foreign self-settled trusts and determined that the law of the debtor's domicile governs the validity of the trust.12 However, no court has addressed the choice-of-law issue in a case involving a domestic self-settled trust. Decisions involving foreign self-settled trusts will be helpful in arguing that the trust is property of the estate under §541(a). However, mere citation to this authority will not be sufficient. Instead, it will be crucial to persuade the court that the reasoning and policies behind these decisions is sufficiently compelling to warrant application in a case involving a domestic trust.

The court in In re Portnoy13 recognized that a self-settled trust seriously affects the debtor-creditor relationship and ignored a choice-of-law provision in a debtor's trust instrument. The court then applied New York law and found that the debtor's trust was property of his estate. In deciding which law to apply, the court balanced the policy interests of the jurisdictions involved, placing great emphasis on the debtor-creditor relationship. The court found that the determination of the validity of the trust had its greatest impact on New York because the debtor lived in New York, a significant number of the debtor's creditors were in New York, and no creditors had contacts with the "offshore" jurisdiction. The court then weighed the interests of New Jersey, the situs of the trust, against New York's interests in regulating the debtor-creditor relationship. Finding that New Jersey's only interest was the generation of business, the court held that New York's interests were paramount.

Some commentators criticize the court's reasoning in Portnoy and assert that courts should instead apply the law the settlor designates.14 The Portnoy court's reasoning, however, is consistent with settled choice of law principles. Courts routinely refuse to apply the law designated in an instrument to disputes involving third parties—including a bankruptcy trustee.15 Indeed, enforcing a choice of law provision when a third party is involved would allow an individual to modify the legal rights of others ex parte.

Moreover, courts have routinely rejected attempts to invoke the laws of a jurisdiction through formalities. For example, in In re Debolt,16 the debtor's spouse obtained a judgment in Ohio granting her a one-half interest in the debtor's pension. The debtor then moved to Pennsylvania and filed a chapter 13 petition. The couple had lived for a number of years in Ohio, the income contributed to the debtor's trust was generated in Ohio, and the judgment was entered in Ohio. Noting these interests, the court found that Ohio had the most significant interest in governing the debtor-creditor relationship that its judgment created. The bankruptcy court in Ohio is not alone in disregarding formalities and asking which state in fact has the most significant interest in the debtor-creditor relationship.17

The same reasoning applies to Delaware and Alaska trusts. Delaware or Alaska, whichever the case may be, clearly has the most significant interest in the administration of trusts located within its borders. The validity of those trusts as between the debtor and a third party, however, is an entirely separate matter. As the Portnoy court noted, the latter relationship is solely a debtor-creditor relationship that the debtor cannot modify ex parte. In the debtor-creditor context, the proper question to ask is: on which state will the impact of a wrong decision fall? A wrong decision in regulating the debtor-creditor relationship will generally fall most heavily on the state where the debtor is domiciled.18 The Portnoy court, therefore, was correct in finding that the law of the state where the debtor is domiciled determines a creditor's ability to reach a trust.19

A debtor may argue that the new Delaware and Alaska legislation is similar to an exemption. Either state could have achieved the same result by exempting trusts from execution. The technical treatment of the property under the Bankruptcy Code would differ if the trust was simply exempt, but the debtor would still ultimately retain the property.20 At first blush, the argument seems persuasive. If Texas can provide a generous homestead exemption,21 what is offensive about trust protection? Each seems susceptible to the same abuse. However, a state's exemptions only apply in bankruptcy when the debtor already has significant contacts, through domicile, to the exempting state.22 A bankruptcy court only applies the exemptions of one state to impair a creditor's ability to collect a debt determined under the laws of another state if the debtor has been domiciled in the exempting state. Because of the domicile requirement, the exempting state already has a substantial interest in regulating the debtor-creditor relationship. The Delaware and Alaska provisions do not guarantee a minimum level of contacts between the debtor and the situs of the trust because they have no domicile requirement. Therefore, a per se rule like the one applied to exemptions is inappropriate.

Conclusion

The developments in Delaware and Alaska will increase the availability and use of self-settled trusts. The unavoidable result is that panel trustees and creditors will face the task of trying to reach these trusts. State or federal fraudulent conveyance law may be available in some cases. However, when the debtor does not have significant contacts with the state in which he established the trust, a panel trustee or creditor may be able to reach the trust through §541(a).


Footnotes

1 The authors thank Prof. Patrick B. Bauer at the University of Iowa for his invaluable contributions to this piece. Return to article

2 See Smith, William C., "Offshore Trust Busting," ABA Journal p.32, November 1999. Return to article

3 Del. Code Ann. tit. 12 §§3570-3576 (1998). Return to article

4 Alaska Stat. §34.40.110 (Michie 1998). Return to article

5 Any creditor holding a support obligation or property settlement pursuant to an "agreement or order of court" can reach a Delaware trust. Del. Code Ann. tit. 12 §3573(1). A pre-transfer tort creditor may also reach the debtor's trust. Del. Code Ann. tit. 12 §3573(2) (1998). Alaska only allows creditors holding a support judgment to reach a self-settled trust if the debtor was in default by 30 days or more on the date of the transfer. Alaska Stat. §34.40.110(b)(4). Alaska provides no exception for pre-transfer tort creditors. Return to article

6 11 U.S.C. §541(a) (1994). Return to article

7 11 U.S.C. §541(c)(2)(1994). Return to article

8 Del. Code Ann. tit. 12 §3570(9)(c). Return to article

9 See In re Portnoy, 201 B.R. 685, 698 (Bankr. S.D.N.Y. 1996); In re Livingston, 186 B.R. 841, 863 (D. N.J. 1995) (New Jersey law determines director liability where New Jersey has a "compelling interest" in resolving the dispute); Securities and Exchange Commission v. The Infinity Group, 27 F.Supp.2d 559, 564-65 (E.D. Pa. 1998); In re Kaiser Steel Corp., 87 B.R. 154, 160 (Bankr. D. Colo. 1988); In re Morse Tools Inc., 108 B.R. 384, 385-86 (Bankr. D. Mass. 1989). Return to article

10 Restatement (Second) Conflict of Laws §270(a) (1971). Return to article

11 Id. Return to article

12 In re Brooks, 217 B.R. 98, 101 (Bankr. D. Conn. 1998); In re Lawrence, 227 B.R. 907, 916 (Bankr. S.D. Fla. 1998); In re Portnoy, 201 B.R. 685, 700 (Bankr. S.D.N.Y. 1996). Because these courts follow the reasoning of the Portnoy court, the piece will focus on the Portnoy decision. Return to article

13 201 B.R. 685 (Bankr. S.D.N.Y. 1996). Return to article

14 See, e.g., Rubin, Daniel S., and Blattmachr, Jonathan G., "Self-settled Spendthrift Trusts: Should a Few Bad Apples Spoil the Bunch?" 32 Vand. J. Transn'l L. 763 (1999). Return to article

15 See Carlson v. Tandy Computer Leasing, 803 F.2d 391 (8th Cir. 1986) (disregarding choice-of-law provision in lease when dispute involved third party); In re Morse Tool Inc., 108 B.R. 384, 386-87 (Bankr. D. Mass. 1989) (refusing to enforce choice-of-law provision to a fraudulent conveyance action brought by a bankruptcy trustee because the trustee was not a party to the contract); In re Eagle Enterprises Inc., 223 B.R. 290, 294 (E.D. Pa. 1998), aff'd. 237 B.R. 269 (E.D. Pa. 1999) (ignoring choice of law provision in an agreement where rights of third parties involved). Return to article

16 177 B.R. 31, 35 (Bankr. W.D. Pa. 1994). Return to article

17 See, e.g., In re Int'l Loan Network Inc., 160 B.R. 1, 16-18 (Bankr. D. D.C. 1993) (disregarding law of state of incorporation in a fraudulent conveyance action in favor of law where transfer occurred and where corporation had principal place of business); In re Kaiser Steel Corp., 87 B.R. 154, 160 (Bankr. D. Colo. 1988) (applying California law to fraudulent conveyance action arising from a leveraged buyout where the transaction was approved in California, and a significant number of the creditors resided in California). Return to article

18 A system that is too pro-debtor will result in higher costs of borrowing for contract debtors, and a higher rate of uncompensated loss for tort victims. A system that is too pro-creditor will result in higher costs for social services as debtors become too destitute to afford the "necessities of life." Return to article

19 See, also, In re Brooks, 217 B.R. 98, 101-102 (Bankr. D. Conn. 1998). Return to article

20 Exempt property becomes property of the debtor's bankruptcy estate, but is then removed from the estate and returned to the debtor. 11 U.S.C. §§541(a), 522(b). Return to article

21 Tex. Prop. Code Ann. §§41.001 and 41.002 (West Supp. 1999) (unlimited value homestead exemption, with area of homestead limited to one acre for a city lot and either 100 or 200 acres for a farm lot, depending on whether the debtor is single or married). Return to article

22 11 U.S.C. §522(b)(2)(A). Return to article

Journal Date: 
Friday, September 1, 2000

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