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Will Declaratory Judgment Actions Be The Savior Of Domestic Asset Protection Trusts? Probably Not.

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A Domestic Asset Protection Trust (DAPT) is a self-settled irrevocable spendthrift trust. In English, this means that a DAPT is trust that one can put their assets into for their own benefit, and then when creditors come along they can stand back and claim that the assets are not available to creditors because of the spendthrift protections of the trust.

The problem is that most states do not allow folks to do this. For instance, California Probate Code section 15304 provides:

(a) If the settlor is a beneficiary of a trust created by the settlor and the settlor's interest is subject to a provision restraining the voluntary or involuntary transfer of the settlor's interest, the restraint is invalid against transferees or creditors of the settlor. The invalidity of the restraint on transfer does not affect the validity of the trust.

(b) If the settlor is the beneficiary of a trust created by the settlor and the trust instrument provides that the trustee shall pay income or principal or both for the education or support of the beneficiary or gives the trustee discretion to determine the amount of income or principal or both to be paid to or for the benefit of the settlor, a transferee or creditor of the settlor may reach the maximum amount that the trustee could pay to or for the benefit of the settlor under the trust instrument, not exceeding the amount of the settlor's proportionate contribution to the trust.

The California provision is typical; the laws of most states refuse to protect the assets of self-settled trusts from creditors.

But not all states. To the contrary, over a half-dozen states, including Tennessee and Ohio, have amended their laws to specifically allow assets in self-settled trusts to be protected from creditors. These states are known, fittingly enough, as "DAPT states", and if you live in one of these states, then you can quite lawfully put your assets into a DAPT, and so long as the transfer was not a fraudulent transfer, then under the laws of the DAPT state the assets will be protected from your creditors.

The question one might then ask is: "What if I don't live in a DAPT state -- can I still take advantage of a DAPT for asset protection?"

The answer is "maybe". The problem is that the laws of the state where the Debtor resides usually applies to the Debtor. If the Debtor is in a non-DAPT state, then the Debtor will probably not gain the protection of a DAPT, so "no" generally.

However, a Debtor could always move to a DAPT state before the creditor begins to enforce the judgment, and in that event the laws of the DAPT state would likely apply.

Where it gets interesting is where the Debtor has assets in the DAPT state, but under the terms of the trust document, the Debtor has no ability to return them to the non-DAPT state where he resides. Nobody knows how this will turn out -- there are no cases that seem to indicate a result either way -- but arguably the courts of the DAPT state could do what courts have done in similar circumstances with the similar Foreign Asset Protection Trust, and hold the Debtor in contempt and incarcerate the Debtor until the assets are returned. We will have to wait for a case to see how all this shakes out.

Where it is not interesting at all is where the Debtor has assets in the non-DAPT state, such as the Debtor's home or other immovable property. In such a case, it is clear that the courts of the non-DAPT state can allow the Creditor to enforce the judgment against that property, regardless of whether it is held in a DAPT in a DAPT state.

Since many folks seeking asset protection have most of their asset in their home or other real estate, this makes DAPTs unattractive for asset protection in non-DAPT states. This also brings me to the subject of this article.

Lately, a theory has been going around that if a Creditor seeks to enforce a judgment against property located in a non-DAPT state (let's say California), which is owned by a Trustee in a DAPT state (we'll use Alaska), the Trustee could commence an action for a Declaratory Judgment in the DAPT state, and if the Trustee "wins first", i.e., obtains the Declaratory Judgment before the Creditor can execute on the property in the non-DAPT state, then the Declaratory Judgment can be registered in the non-DAPT state, and under the Full Faith and Credit Clause of the U.S. Constitution, the non-DAPT state would be forced to honor the judgment.

As happens every so often in asset protection planning, this theory has gone around so much that it is beginning to be accepted as gospel by some planners. But does this theory hold water? No, as I shall now explain.

The first obvious problem is that for the courts of the DAPT state to enter a Declaratory Judgment against the Creditor, the DAPT state must have personal jurisdiction over the creditor. In other words, the creditor must have been doing something in the DAPT state of such a significant nature that it would not offend the U.S. Constitution's Due Process clause to exercise jurisdiction over the creditor.

To go back to our example. Let's say that the Trustee of an Alaska DAPT holds property in California, and a creditor is about to move to enforce the California judgment against the California property. The Theory posits that the Alaska Trustee should immediately file an action in Alaska against the Creditor for a Declaratory Judgment.

The problem will usually be, of course, that Alaska will not have personal jurisdiction over the Creditor. Unless the Creditor was engaged in some significant action in Alaska -- more than just going up there occasionally to do some fishing -- Alaska cannot assert personal jurisdiction over the Creditor such that the Declaratory Judgment would have to be respected by California.

Thus, the Theory fails on this basis, and the DAPT will not protect the California property.

But, let's say that Alaska does have personal jurisdiction for whatever reason over the California Creditor, does that mean that the California Creditor's goose is now cooked?

No. In such an event, the California Creditor could then file a petition in Alaska federal court to remove the action from the Alaska state court. Then, once in federal court, the creditor could invoke the Federal Anti-Injunction Act, 28 U.S.C. § 2283, which provides:

A court of the United States may not grant an injunction to stay proceedings in a State court except as expressly authorized by Act of Congress, or where necessary in aid of its jurisdiction, or to protect or effectuate its judgments.

Section 2283 would prevent the federal court from interfering with the California collection case -- thus allowing the California Creditor free reign to enforce the California judgment against the California property. I know this latter gambit from experience, having myself used it successfully while representing the creditor in the case of New Times Media, LLC v. Bay Guardian, Co., 2010 WL 1909558 (D.Del., 2010).

The bottom line is that there is little reason to believe that a DAPT will effectively protect real estate in a non-DAPT state from creditors. Maybe a bright attorney will someday come up with a strategy that will be successful, but the Theory of rushing to first get a Declaratory Judgment isn't it.

This article at http://onforb.es/183XexA and http://goo.gl/PYVSm