One of the traditional techniques for protecting assets, going back literally hundreds years of Anglo-American jurisprudence, trusts offer tremendous benefits when used appropriate circumstances and often are underutilized for planning. Caution, however, that certain transfers to trusts and types of trusts have been voided by the state legislatures or by Congress in the bankruptcy code.
If you create a trust for your own benefit, you have established a “self-settled trust”. If the trust instrument contains provisions that prevent your creditors from reaching your interest in trust assets, the trust is known as a “self-settled spendthrift trust” (or, more commonly, an “asset protection trust”).
For many hundreds of years, the provisions of self-settled spendthrift trusts designed to protect trust assets from creditors of the settlor/beneficiary were ineffective. Beginning in the 1980’s, certain offshore jurisdictions enacted specially-drafted trust laws overriding this long-standing rule of trust law. Foreign asset protection trusts quickly became popular. In 1999, the rush to form offshore trusts slowed a bit after Michael & Denyse Anderson were jailed for several months for their refusal (or inability, depending on the side from which one views the case) to return funds from their Cook Islands asset protection trust. Foreign asset protection trusts became even less attractive the following year when Stephen J. Lawrence was imprisoned for his refusal to turn over assets from his Mauritius asset protection trust. Lawrence was jailed in August, 2000, and remains jailed today.
In the late 1990s, Alaska led the charge of bringing self-settled spendthrift trusts to the U.S., Delaware, Nevada and a few other states soon adopted similar domestic asset protection trust (DAPT) legislation hoping to attract trust business to their states.
In the last few years, DAPTs appear to have overtaken offshore trusts as the asset protection product du jour, largely because of heavy marketing by trust companies. The popularity of DAPTs is surprising because their benefits are purely theoretical, There have been no cases validating them., The laws of most states, including those of the most populous states, prohibit self-settled spendthrift trusts. Indeed, we and many others have predicted that these trusts have little chance of working for debtors in non-DAPT states.
The heavy marketing of DAPTs had the effect that marketing usually has on asset protection strategies – it attracted the attention of the press, and then, the attention of legislators. Although many bankruptcy reform bills bounced around the halls of Congress for several years none of them contained provisions relating to asset protection trusts. This year, however, while the Act was being debated on the floor of the Senate, the New York Times ran an article about DAPTs and how the rich would be able to protect vast amounts of wealth in these trusts while decades-old bankruptcy protections were stripped away from the poor.
The accuracy of the New York Times article was questionable as the bankruptcy courts had in several previous cases involving the foreign variant simply considered the trust to be an agency arrangement instead of a bona fide trust, thus including trust assets in the bankruptcy estate. Nonetheless, just before passage of the Act, the Senate tacked on an amendment offered by Missouri Senator Jim Talent which may kill the DAPT business just as it was starting to gain momentum.
Section 548 of the Bankruptcy Code relates to “Fraudulent Transfers and Obligations”. Prior to the New York Times article, the Senate had only slightly modified Section 548 by changing the limitations period from one year to two years and some other minor changes. After the article, the Talent Amendment adds a new subsection (e) to Section 548 as follows:
(e)(1) In addition to any transfer that the trustee may otherwise avoid, the trustee may avoid any transfer of an interest of the debtor in property that was made on or within 10 years before the date of the filing of the petition, if--
(A) such transfer was made to a self-settled trust or similar device;
(B) such transfer was by the debtor;
(C) the debtor is a beneficiary of such trust or similar device; and
(D) the debtor made such transfer with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made, indebted.
Since this provision deals what appears to be a fatal blow to asset protection trusts, it is worthy of more detailed discussion.
The 10-year period is measured from the date of the filing of a bankruptcy petition, and there is no grandfather provision for existing trusts. This is a very significant change from previous law, since the ordinary bankruptcy limitations period was only one year (increased to two years by the new Act), and most states have four-year limitations periods for challenging fraudulent transfers.
Next, this 10-year limitations period only applies to self-settled trusts “or similar devices”. The term “self-settled trust” is easy: It is a trust that you create for your own benefit. Asset protection trusts are typically self-settled trusts, as are living trusts.
But what about “similar devices”? Could a bankruptcy trustee use the new Section 548(e) to set aside transfers to trusts that are settled by the debtor, in which the debtor has a limited interest, such as a charitable remainder trust or a qualified personal residence trust? If a transfer to a charitable remainder trust were set aside, the (non-dischargeable) tax consequences to the debtor could be disastrous. Depending on the circumstances, the original deduction could be disallowed, and interest and penalties could apply retroactively.
Another concern of “or similar device” goes to certain types of insurance products, such as “Swiss Annuity” type products and variable universal life insurance products that give their purchasers some investment control, access to cash value, and have only the minimum amount of pure life insurance necessary to satisfy IRS requirements. A sophisticated creditor might make a convincing argument that these arrangements are in the nature of self-settled trusts and are colored with insurance only for technical tax purposes, and thus are within the “or similar device” orbit. With the overt marketing of some financial products, such as private placement life insurance, as asset protection tools, it is not difficult to imagine a court accepting an interpretation of Section 548 by a creditor or trustee to set aside transfers involving some of these types of products.
We are not concerned with ordinary life insurance and annuity products falling into the “or similar device” trap, where they clearly are insurance contracts governed by state insurance codes whose issuers are regulated by state insurance commissioners,. However, our musings here illustrate the vagueness of the “or similar device” language of Section 548(e) and the potential for its interpretation to encompass many asset protection strategies. It may be some time before we have sufficient case law to be able to say with any certainty that particular strategies fall into or avoid that trap.
It is clear that that the language of Section 548(e) protects future creditors, not just creditors existing at the time of the transfer. Section 548(e)(1)(D) refers to to existing creditors and to those who became creditors “on or after the date that such transfer was made.” Congress clearly intended that Section 548(e) apply for the benefit of creditors who appeared only after the transfer occurred. Nonetheless, many promoters falsely proclaim that there is no fraudulent transfer risk if there are no current creditors’ claims.
While the fact that a person has no claims against him at the time of a transfer certainly is favorable, it is not dispositive. Indeed, the same language referring to future creditors appears in (unchanged) Section 548(a)(1). Similar provisions appear in the Uniform Fraudulent Transfer Act, which expressly protects future creditors in many circumstances.
There have been some suggestions that the “actual intent” language means that a transfer to a self-settled trust can only be set aside if the debtor confesses that he intended to defraud creditors. Of course, no sober debtor would make such an admission if significant wealth was at risk. Thus, Congress used the exact same phrase that appears in Section 4(a)(1) of the Uniform Fraudulent Transfer Act: “actual intent to hinder, delay, or defraud.” The same phrase appears in Section 548(a)(1)(A) and is part of the principal fraudulent transfer provision of the Bankruptcy Code, that was unchanged by the new Act.
Under both the UFTA and Section 548(a)(1)(A), it is clear that “actual intent” does not require a confession by the debtor. To the contrary, “actual intent” long has been proved by circumstantial evidence consisting of certain factors (the “Badges of Fraud”) that would indicate the debtor’s fraudulent intent. So even if a debtor professes innocence and points to substantial non-asset protection reasons for making transfers, the court may still find that the debtor had the “actual intent to hinder, delay, or defraud” if the circumstances tend to indicate that to the judge.
There is also a new subsection (e)(2) that makes it clear that subsection (e)(1) also applies to transfers in anticipation of a judgment or fine, etc., arising from a violation of state or federal securities laws, or “fraud, deceit, or manipulation in a fiduciary capacity or in connection with the purchase or sale of any security”. Some have misread subsection (e)(2) to infer that the new 10-year limitations period for self-settled trusts applies only to securities fraud or breach of fiduciary duty, etc., but the “includes” language of (e)(2) is purely supplementary and not limiting.
It is important to keep in mind that the bankruptcy courts were in the habit of considering self-settled trusts to be in the nature of agency relationships, and thus were including self-settled trust assets in the bankruptcy estate anyway. There is no 10-year statute of limitation for this, so even those with “old and cold” asset protection trusts may be sadly disappointed in bankruptcy if their overall arrangement gives (direct or, as is the norm, indirect) control over the distribution of trust assets to the settlor/beneficiary.
If settlors of old and cold APTs clearly do not have control over the distribution of trust assets to themselves, the assets of such trusts would not be included in their bankruptcy estates. However, this presupposes at least two things: first, that there are APT settlors who truly have no direct or indirect ability to compel a trustee to make distributions to them; and second, that a bankruptcy trustee and/or judge would resist a likely urge to disregard the trust as an agency relationship in any event.
The effect of new Section 548(e) is that if asset protection trusts were not dead before, they should not now be used as anything like an ordinary asset protection technique. In more circumstances than not, it may now be the precipice of malpractice to recommend an asset protection trust to a client. The rare exception will be for those who establish foreign asset protection trusts and who are willing and able to flee the U.S. before the court enters the inevitable repatriation order.
