On August 11, 2014, I first wrote about the Castellano case in my article, Trust Beneficiary Checkmated By Bankruptcy Code 548(e) In Castellano.
In a nutshell, Faith Campbell created a Living Trust for the benefit of her four children in 1997. Faith died in 2007, and one her children, Linda Castellano, and her husband declared bankruptcy in 2011. The issue is whether the assets that were retained in the Living Trust, which had a spendthrift provision that protect the interests of beneficiaries (such as Linda) became property of her bankruptcy estate.
In an Opinion which I thought at the time ran off the rails and crashed in error into the weeds on a number of issues, the Bankruptcy Court held that Linda's beneficial interest in the Living Trust were indeed includable in her bankruptcy estate and thus accessible by the Bankruptcy Trustee. The least tenable ruling by the Court was that under Bankruptcy Code section 548(e), because Faith's Living Trust was a self-settled trust as to her, Faith's transfers to the trust could be set aside some 14 years later as to creditors of Linda, a ruling that ranks at least a 9 on the Juris Wrong-O-Meter.
Thereafter, Linda and J.T. Del Alcazar, the latter being the current trustee of the Faith Campbell Living Trust, objected to the Bankruptcy Court's decision on review by the U.S. District Court for the Northern District of Illinois -- and cited my article in a couple of instances. The U.S. District Court reversed the findings of the Bankruptcy Court, and ruled in favor of Linda and Del Alcazar and against the Trustee, as I shall now relate.
To save time, I'm not going to fully review the pertinent facts again -- to understand this sequel, you'll need to read my original article first as we will here join the U.S. District Court's Opinion already in progress.
The District Court started its analysis with a very basic point of bankruptcy law which the Bankruptcy Court had seemingly missed, which is that if Linda's interest in Faith's Trust was excluded from Linda's bankruptcy estate under Bankruptcy Code section 541(c)(2), then the Bankruptcy Trustee doesn't have any legal grounds to avoid that interest's transfer, since even if were avoided that interest would not be part of Linda's bankruptcy estate.
In other words, Linda and/or Del Alcazar as Trustee of Faith's Trust had allegedly made transfers of Linda's interest to dodge the Bankruptcy Trustee's collection efforts. But if Linda's interest was not part of her bankruptcy estate anyway, then it doesn't make any sense to set these transfers aside since the Bankruptcy Trustee has no right to pursue those assets in the first place; a legal variation of "no harm, no foul".
So, the biggest question in the case was whether Linda's share of Faith's Trust was in Linda's bankruptcy estate or not. The Bankruptcy Court looked at the Trust language that said "Upon the death of Faith F. Campbell and upon settlement of her estate, this Trust shall terminate", and concluded that Faith's Trust terminated the moment she died, and all that "upon settlement of her estate" language was little more than administrative surplusage.
The District Court rejected this analysis, starting with an examination at all the other terms of the Trust which set out numerous provisions relating to how the Trust should be run for the benefit of its beneficiaries -- all of which makes no sense if the Trust terminated immediately on Faith's death. Moreover, the Trustee of Faith's Trust had numerous duties to perform to, if nothing else, wind down the Trust and pay Faith's last expenses, all of which would keep the Trust alive after Faith's natural expiry had been reached.
So, the District Court concluded, Faith's Trust did not terminate upon her death, but continued to live a vibrant existence even as of the time that Linda commenced her bankruptcy case.
The next step in the analysis was to determine whether Linda had any right to the Trust assets on the day that she filed for bankruptcy. Here, the terms of the Trust prevented Linda from selling or encumbering her interests in the Trust, and the Trust assets were well protected from Linda's creditors under the Trust's spendthrift provisions. Thus, the District Court:
So, on the question of whether the Living Trust sought to restrict the transfer of its beneficiaries' interests, the precise answer is: Yes, twice.
Since the anti-alienation and spendthrift provisions were valid under the laws of any state whose laws might apply (here, South Carolina, Illinois and Wisconsin -- the parties were squabbling about which state's laws applied) then Linda's share of the Trust assets were properly excludable from her estate under Bankruptcy Code 541(c)(2). I will omit for brevity the Court's analysis of the spendthrift laws of those three states, but suffice it to say that the District Court ruled that Linda's share of the Trust's assets would be protected no matter which state's laws applied.
Finally, this brings us to the Bankruptcy Court's bizarre application of Bankruptcy Code section 548(e) to this case, which, it will be recalled, that because Faith's Trust was self-settled as to Faith, then the Trust failed on that basis as to Linda -- a ruling by the Bankruptcy Court that, in the humble opinion of your writer, failed to rise even to the level of respectable nonsense.
The District Court made short shrift of this ruling:
The record does not support application of sec. 548(e) in this case. "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." 11 U.S.C. sec. 548(e). At all times, Castellano's potential share remained the property of the Living Trust in the custody of Merrill Lynch. Although [the Trustee of Faith's Trust] segregated a portion of the Living Trust into a second account at Merrill Lynch earmarked for potential discretionary distributions to Castellano, that act did not end the Living Trust's ownership of those funds, constitute a distribution to Castellano, or create a new trust. It was simply a division of trust property as permitted by sec. 4.02(b) of the Living Trust. Accordingly, because there was no transfer of an interest of the debtor, sec. 548(e) does not apply.
Thus, the District Court overturned the Bankruptcy Court, and held in favor of Linda and Del Alcazar.
ANALYSIS
We dodged a bullet on this case, since the Bankruptcy Court's ruling on 548(e) was so expansive that virtually every living trust was susceptible to being set aside as a "self-settled trust" even after the settlor died and the interests of the beneficiaries which would normally be protected, thus would have become available to creditors in bankruptcy.
This does illustrate, however, that 548(e) is still substantially subject to new interpretation, and in many ways we really don't know how the law in this area is going to ultimately shake out.
On the other hand, this ruling creates greater certainty that trusts don't necessarily terminate immediately upon the death of the settlor so long as there are duties remaining for the Trustee to perform, including the long-term administration of the trust to benefit its beneficiaries. While particular drafting issues and the laws of some states might still create issues ripe for litigation, we can still sleep much better now at least as to how most trusts will be treated.
Our legal system is not perfect, but there are checks and balances in the appeals process that create a much greater likelihood that the right outcome will ultimately be reached, as here.
And that's a very good thing.
CITE AS
Safanda v. Castellano, 2015 WL 1911130 (N.D.Ill., April 27, 2015). Full Opinion at http://goo.gl/5cU8bv
This Article at http://onforb.es/1Fzw7ej and http://goo.gl/C6PBzS
