For decades, Delaware has served as a panacea for business planning. Business filings are relatively cheap, there is no income tax applicable to a business not operating in Delaware, and Delaware has proactively implemented innovative business legislation, such as the series LLC.
Yet, overlooked by many lawyers is the fact that Delaware’s demographics have changed over the past several decades. What used to be a relatively bucolic state sandwiched between New Jersey and Pennsylvania is increasingly becoming a metropolitan suburbia. The average Delaware voter has become increasingly progressive, and the consequences are bearing out in the Delaware legislature.
Over time, we see an emerging trend in Delaware, and it does not bode well for either businesses or trust planning in that state. In particular, two powerful forces are working to diminish the viability of Delaware as a state for asset protection planning: (i) the plaintiff’s bar, which has become a dominating force in the state legislature, and (ii) the Delaware courts, which do not seem anxious to defend Delaware’s domestic asset protection trust laws.
The Power of the Plaintiff’s Bar in Delaware
In 2014, the Delaware Supreme Court approved the use of a fee shifting provision in ATP Tour, Inc. v. Deutscher Tennis Bund, No. 534, 2013, 2014 Del. LEXIS 209 (Del. May 8, 2014). The idea behind a fee shifting provision is that a corporation may recoup its expenses incurred in defending itself (and its directors and officers) from a shareholder lawsuit, should the shareholder not succeed in the lawsuit. This has the effect of implementing the “loser pays” rule of litigation expenses found universally in common law jurisdictions outside the United States.
One would expect a pro-business jurisdiction such as Delaware to recognize the efficacy of such a provision. Therefore, it was not particularly surprising when the Delaware Supreme Court recognized the facial validity of the provision in an en banc ruling. The opinion spoke in terms of general legal principles affecting corporations in Delaware and the desire to deter needless litigation through the use of a fee shifting provision.
Unfortunately, soon after the Delaware Supreme Court decided ATP Tour, Inc., the Delaware Corporate Law Council suggested amendments to Delaware corporation law that would prevent the use of fee shifting provisions in the bylaws of regular stock corporations. The draft legislation proposes to create a new Section 331 of the Delaware General Corporation Law, and it would generally bar a corporation’s articles or bylaws from charging shareholders with liability or responsibility for corporate debts, aside from a narrow set of special circumstances (e.g., in relation to stock transfer restrictions, or for certain capital call scenarios). As the Wall Street Journal describes it:
Weeks after the court’s ruling, the Delaware legislature, cheered on and supported by the powerful state plaintiffs bar, attempted to pass a law “fixing” the Delaware Supreme Court’s decision. Far from a fix, the bill would have outlawed a company’s ability to use the fee-shifting tool to protect itself against frivolous litigation.
According to the U.S. Chamber Institute for Legal Reform, a branch of the U.S. Chamber of Commerce, in 2010 and 2011, 91% of all mergers and acquisitions involving publicly-traded companies were embroiled in litigation shortly after knowledge of the transaction became public. As the Institute highlights in their report, most such litigation settles within three months and results in very little to no benefit to shareholders. However, the trial lawyers reap large fees from this practice. The Institute characterizes this as “extortion through litigation,” whereby mergers and acquisitions incur a “litigation tax” that transfers wealth from shareholders to lawyers.
A separate study by Cornerstone Research in 2012 found that publicly-traded companies involved in mergers on average have to defend against five separate shareholder lawsuits in multiple jurisdictions on the same transaction. The prospects for litigation are exacerbated by the fact that the Delaware Chancery Court permits shareholders – who purchase their shares after a deal is announced – to bring a lawsuit on the deal. Merion Capital, L.P. v. 3M Cogent, Inc., C.A. No. 6247 (Del. Ch. July 8, 2013).
Fee shifting provisions in corporate bylaws would help to curtail lawsuit abuse. A prospective plaintiff would need to consider the merits of a claim before bringing them; settlements for “nuisance value” would be discouraged. Legal scholars who have researched this believe that a loser-pays rule would cause settlements to taper off and litigation to become longer and more substantial as the risk-reward dynamic of shareholder litigation changes.
Kloiber: No True “Asset Protection” Available in Delaware
Foreign asset protection trusts have enjoyed decades of litigation success, fending off creditor attacks and preserving family assets for succeeding generations. Unfortunately for this trend, a number of asset protection lawyers — motivated more by fees to provide domestic trust services than to serve their clients’ best interests –jumped on the domestic asset protection trust bandwagon starting approximately 20 years ago. Since then, 17 states have enacted some form of explicit asset protection trust legislation.
Delaware was one of the early adopters of asset protection trust legislation, enacting the Qualified Dispositions in Trust Act in 1997. Chapter 35, Subchapter VI of Title 12 of the Delaware Code reflects the codification of this legislation.
Section 3572 therein contains the operative provisions that purport to cut off creditor claims once a Delaware trust has been properly established and funded. Under paragraph (a), creditor claims arising after the trust was funded are supposedly barred unless the creditor can prove actual intent by the transferor to defraud the creditor at the time the transfer was made in trust. The statute further provides that, “The Court of Chancery shall have exclusive jurisdiction over any action brought with respect to a qualified disposition.” 12 Del. Code § 3572(a).
The “exclusivity clause” contained in the Delaware law appears to have been motivated by similar laws enacted in offshore asset protection trust jurisdictions such as Belize, the Cook Islands, and Nevis. However, it is drafted quite differently. Compare, for example, Section 7(6) of the Belize Trust Act, which prohibits a Belize court from varying or setting aside any trust, or recognizing the validity of any claims against the trust, based on the law or a court order of a foreign jurisdiction. Similarly, Section 13D of the Cook Islands International Trusts Act bars the recognition or enforcement of any judgment arising from a foreign jurisdiction. Section 3572(a) does not purport to bar the enforcement of foreign claims, but to simply confirm the “exclusive jurisdiction” of Delaware’s Chancery Court.
The Kloiber Dynasty Trust
In 2002, Glenn Kloiber settled an irrevocable dynasty trust with PNC Bank, Delaware as the trustee. The trust agreement expressly chose Delaware law as the governing law for the trust, and the agreement specified Daniel Kloiber and his “spouse,” among others, as beneficiaries of the trust. The trust was funded with, among other assets, shares of stock in a company that was eventually bought out for approximately $300 million.
Fast forward a few years, and in 2010 Daniel Kloiber and his wife, Beth, filed for divorce in Kentucky. Daniel took the position that, under the terms of the trust agreement, completion of the divorce would mark the end of Beth Kloiber as a discretionary beneficiary of the family’s dynasty trust, as she would no longer be his “spouse.” Beth was not otherwise specifically named as a beneficiary in the trust agreement, which Daniel argued was not by chance but intentionally designed to void her interest on divorce.
The Kentucky court issued a “status quo” order intended to prevent the dissipation of marital assets pending resolution of the divorce proceedings. This order was supplemented in 2012 with a separate order identifying the Kloiber dynasty trust as an asset subject to the status quo order. Following a 12-day trial in 2013, the Kentucky court issued a further status quo order confirming the court’s continued jurisdiction over the Kloiber dynasty trust.
Notwithstanding his previous compliance with the status quo orders, in 2013 Daniel applied for a writ of prohibition in Kentucky, attempting to prevent the Kentucky court from exercising further jurisdiction over the dynasty trust. Earlier this year, a court of appeals in Kentucky denied the writ, explaining that the Kentucky court had valid subject matter jurisdiction over the trust. The court pointed to certain terms of the trust agreement that made Daniel a primary beneficiary as well as a “Special Trustee” with certain trustee-like powers over the trust assets. Also, Daniel was the manager of several LLCs wholly-owned by the dynasty trust. Subsequent to this ruling, the lower court adjudicating the divorce proceedings added PNC Bank as an additional named defendant in the litigation.
Subsequent to Daniel’s loss on the writ argument, Daniel resigned as the “Special Trustee,” and PNC Bank petitioned the Delaware Chancery Court to intervene and grant an order precluding the enforcement of the Kentucky court’s orders. PNC argued that the Delaware courts have exclusive jurisdiction over Delaware trustees, and that Kentucky lacked personal jurisdiction over PNC Bank. In the meantime, the Kentucky court found Daniel in contempt for having resigned as Special Trustee, and the Kentucky court ordered a show cause hearing to determine whether Daniel’s family member, Nick, should be held in contempt for acting as the successor Special Trustee in violation of the court’s order.
Delaware Chancery Court: No Protection for Delaware Asset Protection Trusts from Outside Litigation
The Delaware Chancery Court considered Nick’s request, as part of the Delaware litigation, whether to grant a temporary restraining order, i.e., anti-suit injunction, in Delaware blocking the enforceability of any rulings emanating from the Kentucky divorce court proceedings. Citing 12 Del. Code § 3572(a), PNC Bank — in support of Nick’s petition — argued that the Delaware courts have exclusive jurisdiction over trusts governed by the Delaware APT law, the Qualified Dispositions in Trust Act.
The Chancery Court disagreed with Nick and PNC Bank. The judge pointed out that the Delaware Code is riddled with similar provisions concerning the “exclusive” jurisdiction of a court. The judge further observed that such language only means that the Chancery Court has jurisdiction to the exclusion of any other Delaware state court:
By stating that a particular Delaware court has exclusive jurisdiction over a particular statute, the General Assembly makes clear which of Delaware’s trial courts will handle the identified matters. * * * In Delaware, specifying that exclusive jurisdiction has been assigned to a court is particularly important because of the residual equitable jurisdiction of the Court of Chancery. * * * The General Assembly also has designated a particular court as having exclusive jurisdiction in order to alter a pre-existing allocation of jurisdiction. * * * When a Delaware state statute assigns exclusive jurisdiction to a particular Delaware court, the statute is allocating jurisdiction among the Delaware courts. The state is not making a claim against the world that no court outside of Delaware can exercise jurisdiction over that type of case.
(Emphasis added.)
If one was expecting the Chancery Court to stop at this point, one would be surprised: The Chancery Court then proceeded to analyze the potential application of Federal pre-emption and the Full Faith and Credit Clause of the U.S. Constitution. This is the worst nightmare of Delaware trust practitioners. First, as to Federal pre-emption, the Chancery Court sensibly observed that the Supremacy Clause of the U.S. Constitution dictates that Federal law would pre-empt any assertion of “exclusive” jurisdiction by the courts of Delaware in a Federal court proceeding affecting the trust. Then, the Chancery Court expounded on the Full Faith and Credit Clause, driving a nail in the coffin for domestic asset protection trusts:
In my view, Delaware also cannot unilaterally preclude a sister state from hearing claims under its law. The fifty states in our federal republic are peers. Although there is no horizontal constitutional mandate so clear as the Supremacy Clause, the Full Faith & Credit Clause comes close. It provides that “Full Faith and Credit shall be given in each State to the public Acts, Records, and judicial Proceedings of every other State.” U.S. Const. art. IV, § 1. If Delaware sought to preclude a sister state from hearing a matter of Delaware law, it would not be giving constitutional respect to the judicial proceedings of the sister state. In the converse scenario, the United States Supreme Court has interpreted the Full Faith & Credit Clause as requiring that state courts not only respect the laws of their sister states but also entertain claims under their laws. I do not believe the “exclusive jurisdiction” language in the Qualified Dispositions Act would be effective, even if it meant what PNC thinks it means.
(Emphasis added.)
All was not lost, however. The Chancery Court did not want to indicate what would happen if the Kentucky court issued a ruling based on a fraudulent conveyance theory, cryptically explaining:
There is no colorable claim based on the Kentucky Family Court‟s alleged interference with any exclusive jurisdiction of this court. In my view, Delaware has not sought through the Qualified Dispositions Act to arrogate exclusive jurisdiction for itself, nor could it. There are also circumstances where, depending on how the Kentucky Divorce Proceeding plays out, the relief granted by the Kentucky Family Court could co-exist peacefully with the restrictions in the Qualified Dispositions Act.
The opinion begged the question: What happened if the relief granted by the Kentucky court did not “co-exist peacefully” with the restrictions in the Qualified Dispositions Act? Moreover, what if the Kentucky court had applied a legal theory aside from fraudulent conveyance, such as the sham/alter ego doctrine, to disregard the Delaware trust as an abusive sham, voiding it as against public policy?
Analysis
In our view, once the judge acknowledged the applicability of the Full Faith and Credit Clause, the rest of the opinion becomes superfluous. The explicit recognition of the Full Faith and Credit Clause by the Chancery Court gave real force to the argument that a judgment issued by a Kentucky court and originating under Kentucky divorce law may be applied against the assets of a Delaware trust, notwithstanding the Qualified Dispositions in Trust Act. One would not expect the Kentucky divorce court to feel compelled to follow the dictates of Delaware law governing “qualified dispositions in trust” where Kentucky law conflicts, particularly on a fraudulent transfer. Consider this in light of the California decision in Kilker v. Stillman, wherein the selection of Nevada law for a domestic asset protection trust was considered a per se “actual intent” fraudulent transfer to be governed under California law, notwithstanding the choice of Nevada law for the trust. The Delaware Chancery Court’s ruling enables the court of any other state to effectively set aside a Delaware trust.
The Delaware Chancery Court acknowledges as much in its ruling. In evaluating the ability of Delaware to enforce an exclusivity clause against Beth, the Chancery Court pointed out that Beth is like the typical commercial creditor in an asset protection trust case: Beth did not “choose” Delaware law to govern her claim against her husband in divorce.
This case differs from a situation where parties have agreed voluntarily by contract to an exclusive forum. Beth did not execute the Trust Agreement, nor is there any indication that she chose explicitly or implicitly to become bound by its terms. She does not appear to have participated in or approved the Exstream transfer.
An untested argument that has always lurked around domestic asset protection trusts is that the choice of law governing the trust should only be effective vis-a-vis the parties to the trust agreement. By comparison, a creditor who has never accepted the choice of law governing the trust should not be bound by that jurisdiction’s laws governing the creditor’s remedies in another jurisdiction. If Daniel Kloiber engaged in fraudulent transfers to a Delaware trust, Kentucky law should properly determine the fraudulent transfer issue, not Delaware, and Kentucky law should define the liability of the Delaware trustee as a fraudulent transferee.
Conclusion
These recent developments in Delaware cannot go unnoticed. If the plaintiffs’ bar can move the Delaware legislature to consider banning fee shifting provisions, then it is merely a function of time before lobbyists explore other plaintiff-friendly legal reforms in Delaware. This bears not only on Delaware’s reputation as a business-friendly state for corporate law matters, but an asset protective state for trusts and the banking industry.
Many Delaware estate planning lawyers will argue that the facts of Kloiber are unique, or that critics of Delaware law are simply promoting business in a competing jurisdiction. To the first point, no, Kloiber did not have unique facts: People get divorced all the time, and we often see a spouse seek to attach assets of a trust in divorce proceedings. Delaware is unable to address this concern satisfactorily through its legislation. Furthermore, the Delaware Chancery Court appeared to go out of its way to volunteer that a Delaware trust is worthless in out-of-state divorce proceedings.
To the second point, yes, we criticize Delaware because there are better jurisdictions in which to engage in asset protection trust planning. The simple fact is that a few clever lawyers and bankers conspired to promote Delaware as a plausible domestic asset protection trust jurisdiction, but they are unwilling to own their failures. One of the primary promoters of Delaware trust planning, a New York City lawyer who frequently goes on the asset protection lecture circuit, is compensated by a Delaware trust company for his services.
We do not compensate anyone to advocate for one of the jurisdictions in which we operate. The jurisdiction has to stand on its own merits. Otherwise, as in the case of Delaware, lawyers needs to fulfill their professional obligation of warning their clients that there is no such thing as a Delaware “asset protection” trust.