We warned that this would happen…
Foreign asset protection trusts have enjoyed profound success over the past three decades of their existence (dating back to the codification of the first ever asset protection trust law in the Cook Islands). With time, we anticipated that one or more states in the USA might take a shot at enacting its own asset protection trust law to compete with offshore APT jurisdictions such as the Cook Islands.
Ever since Alaska and Delaware introduced their respective domestic asset protection trust (“DAPT”) laws, a fierce debate has taken place in legal conferences: Is a domestic asset protection trust as effective as a foreign asset protection trust (“FAPT”)? A number of criticisms have been leveled regarding the efficacy of DAPTs, including that:
- The Full Faith & Credit Clause of the US Constitution requires that a judgment obtained against the debtor or trustee in another state be enforced in the trustee’s DAPT state.
- The Bankruptcy Act’s 10-year clawback for transfers into spendthrift trusts bars the practical use of a DAPT in the bankruptcy setting.
- A court in the debtor’s home state, in which DAPTs are not recognized, may object to the application of another state’s DAPT laws as void against public policy.
In re: Huber
A federal court recently weighed in on these issues and, as predicted by many critics over a decade ago, an Alaska DAPT has been rendered invalid and unenforceable in the U.S. federal court system. In Waldron v. Huber (In re: Huber), 2013 WL 2154218 (Bk.W.D.Wa., Slip Copy, May 17, 2013), a debtor residing in Washington settled an Alaska DAPT in anticipating that he might incur liability on a personal guaranty for a business loan. The settlor, beneficiaries, and trust assets were all located in the State of Washington, except for a $10,000 certificate of deposit placed by the trustee with a bank in Alaska.
Reviewing the extent of contacts in the State of Washington, the federal bankruptcy court applied Section 270 of the Restatement (Second) of Conflict of Laws to determine the applicable law of the trust. Section 270 normally recognizes a settlor’s freedom to select the applicable law for his or her trust, so long as the law chosen by the settlor “does not violate a strong public policy of the state with which, as to the matter at issue, the trust has its most significant relationship * * *.” The court noted the minimal contacts between the settlor and the State of Alaska, including the modest bank deposit, contrasting this with the fact that Washington is one of many states that has a strong public policy against the use of self-settled spendthrift trusts to avoid creditors. The court therefore voided the transfers in trust.
Separately, the bankruptcy court also ruled that, under Section 548(e) of the Bankruptcy Act, the 10-year clawback applied to treat contributions to the trust as fraudulent transfers. The court took particular aim at the selection of Alaska law as evidence of a specific intent to evade, defeat, or hinder a creditor.
We have observed the steady encroachment on DAPTs by federal and state courts over the past two years. Last year’s ruling in Kiker v. Stillman, 2012 WL 5902348 (Cal.App. 4 Dist., Unpublished, Nov. 26, 2012), found that a California debtor’s selection of Nevada law for a DAPT was inherently fraudulent as against creditors, thereby rendering all contributions to a Nevada DAPT invalid as fraudulent transfers. While Kiker is a state court decision, the ruling in In re: Huber is a federal bankruptcy decision that is likely to be followed uniformly throughout the states.
Where does this leave trust settlors in their asset protection planning?
- DAPTs Are a Bad Idea: First, the use of a DAPT for asset protection planning is folly, leaving the client unprotected while exposing the attorney recommending the DAPT to malpractice liability. It is abundantly clear that DAPTs are vulnerable in the federal court system. However, even if Huber resided in Ohio (a DAPT state) rather than Washington, the outcome would have been the same: Application of the 10-year clawback and the deconstruction of the trust on fraudulent transfer grounds.
- If You Are an Attorney Recommending DAPTs, Prepare to be Sued for Malpractice: We have voiced our concerns about attorney malpractice for some time now, particularly when Ohio announced its DAPT law, which appears ineffective on its face. Yes, one may string along a set of facts by which an Ohio resident with Ohio assets and an Ohio creditor might, just might, be protected under Ohio’s DAPT law by keeping creditor proceedings out of the federal court system, but the odds of this happening are about as likely as lightning striking twice in the same place.
- The FAPT Vehicle is Maturing in its Own Right: Sometimes too much of a good thing can breed its own concerns. FAPTs have enjoyed unparalleled success over the past several decades, but this has caused creditors’ attorneys to sharpen their swords and seek out new angles of attack. FAPTs are designed with the understanding that, in all likelihood, the FAPT will be disregarded in a U.S. court and that contributions to the FAPT will be subject to collection under an adverse judgment. However, FAPTs are designed to survive such an attack by maintaining the trust and trust assets outside the reach of U.S. courts. Creditors are increasingly responding to FAPTs by searching out trust assets and seeking to bypass the trust, and enforce a judgment, wherever assets can be located domestically (such as a trust account at a U.S. bank or brokerage firm titled in the name of the trust or a subsidiary entity of the trust).
- LLCs Will Continue to Rise in Popularity as Asset Protection Planning Vehicles: We have previously counseled that FAPTs contain an optically inherent vulnerability as reflected in Kiker and referenced in Huber… If a debtor establishes a trust under the laws of an asset protection jurisdiction, whether foreign or domestic, increasingly courts will regard such action to be prima facie evidence of a specific intent to evade, hinder, or defeat a creditor. If a debtor chooses to utilize an APT, contributions to the APT may be regarded as fraudulent transfers almost automatically. Again, FAPTs enjoy an advantage over DAPTs in that they are designed to enjoy immunity from of an adverse U.S. court judgment on the fraudulent transfer issue. Still, in cases where the fraudulent transfer issue is relevant — particularly as to assets that must remain in the United States — we expect to see asset protection planners migrate from the use of FAPTs to LLCs, particularly LLCs established under the laws of an asset protection jurisdiction such as Belize. When assets are transferred to an LLC as part of a well thought out business plan, the asset protection planner and the debtor-client gain from the ability to assert a number of defenses to the inevitable fraudulent transfer arguments to be made by creditors.