In 1978, Sally Zukerkorn's husband passed, and shortly thereafter she created a fully revocable Trust of which she was all of the grantor, individual trustee, and lifetime beneficiary, and to which she had full access to everything during her lifetime. Sally additionally named American Trust Co. of Hawaii, Inc., as the corporate trustee.
Sally's Trust contained a typical spendthrift clause, but also a choice-of-law clause provided, "This instrument and the dispositions under it shall be construed and regulated and their validity and effect shall be determined by the law of Hawaii."
A few years later, in 1982, Sally amended her Trust so that upon her passing, the Trust would split into two separate Trusts for her two sons, Herbert (our Debtor) and Jack. What happened to Jack's Trust is irrelevant to our story, so we'll forget it.
What you need to know is that Herbert was able to sell Sally's real estate in 2003 and place $2 million into his Trust, of which he was now both the (apparently sole) Trustee and Beneficiary, and that by 2010, Herbert and his wife had gone bust and filed for Chapter 7 relief in bankruptcy in California where they resided.
Herbert claimed that Hawaii law governed his interest in the Trust, and -- in accordance with the spendthrift provision -- valued his interest at "$0.00" -- although the Herbert was getting about $12,000 in combined income from the Trust.
The Bankruptcy Trustee took umbrage at Herbert's valuation of his interest, and filed a Turnover Motion for 25% of the distributions paid to Herbert by the Trust. The Turnover Motion contended that California law should apply, not Hawaii law.
Under California law [FN1] the Trustee was entitled to 25% of distributions. By contrast, under Hawaii law, all of Herbert's interest would have been protected, and the Trustee shut out.
The Trustee alternatively argued that the property was owned by the bankruptcy estate because Herbert's interest was "acquired" within 180 days of when Herbert filed his Chapter 7 petition. [FN2]
The Bankruptcy Court ruled in favor of Herbert, rejecting the Trustee's arguments, but the Trustee appealed to the 9th Circuit, and thus the Bankruptcy Appellate Panel consisting of three judges faced these two issues. The panel split 2-1, with a lengthy dissent which we will consider in a moment, but for now let's stick with the two jurists who agreed.
The Majority Opinion
The Majority (of two) noted that both the Ninth Circuit and California adopt the Second Restatement on Conflicts of Law to determine choice of law rules. The Restatement looks at seven public interest factors to determine which forum's laws should apply.
Since, according to the Majority, trust law is the result of an overlap between contract law and property law, the Majority would look to both the contract law and property law treatment of choice of law under the Restatement.
The contract law treatment of the Restatement (section 187) looks to apply the law of whichever forum best carries out the intent and expectation of the contracting parties, so long as that forum has a substantial relationship to the contracting parties and the transaction. This analysis includes the "protection of justified expectations", i.e., making sure that the parties get the benefit of their bargain.
The Majority also looked to the Restatement specific to trusts:
The creation of a trust is a method by which the owner of property makes a disposition of it. The chief purpose in making decisions as to the applicable law is to carry out the intention of the creator of the trust in the disposal of the trust property. It is important that his intention, to the extent to which it can be ascertained, should not be defeated, unless this is required by the policy of a state which has such an interest in defeating his intention, as to the particular issue involved, that its local law should be applied . . ." [FN3]
and
Law designated by the settlor to govern validity of the trust. Effect will be given to a provision in the trust instrument that the validity of the trust shall be governed by the local law of a particular state, provided that this state has a substantial relation to the trust and that the application of its local law 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.
A state has a substantial relation to a trust when it is the state, if any, which the settlor designated as that in which the trust is to be administered, or that of the place of business or domicile of the trustee at the time of the creation of the trust, or that of the location of the trust assets at that time, or that of the domicile of the settlor, at that time, or that of the domicile of the beneficiaries. There may be other contacts or groupings of contacts which will likewise suffice. [FN4]
Against, the factors, the Bankruptcy Trustee had argued that California had a greater interest in having its laws apply to the dispute, mainly so that "trust-fund babies" (as the Trustee called them) would not be treated better than wage earners, whose wages are can be garnished up to 25% in the Golden State. The Trustee also pointed out that our Debtor, Herbert, had chosen Northern California to file his bankruptcy petition, and has been a California resident.
But the Majority rejected these arguments, and launched off into a convoluted and seemingly result-oriented decision (thus drawing the Dissent) that sought to respect Sally's desires as the now-deceased trust settlor that Hawaii law would apply to her trust. The Majority also focused on the fact that the assets were originally maintained in Hawaii, and not California, to bolster the holding that Sally's expectation was "reasonable".
Very importantly, for those who might attempt to apply this decision to validate so-called Domestic Asset Protection Trusts (DAPTs), the Majority was careful to distinguish that the trust here was not a self-settled trust as it related to Herbert -- even though it certainly was a self-settled trust as it related to Sally. This was important, because "self-settled trusts are void and against public policy in California", the Majority held, and if a self-settled trust had been involved, that would have been against California's public policy and thus (presumably) California law would have applied instead of Hawaii law.
On the issue of self-settled trusts, the Majority quoted a 1949 California Supreme Court for the proposition that:
It is against public policy to permit a man to tie up his property in such a way that he can enjoy it but prevent his creditors from reaching it, and where the settlor makes himself a beneficiary of a trust any restraints in the instrument on the involuntary alienation of his interest are invalid and ineffective. [FN5]
The Majority discounted the argument that California law should apply to Herbert's interest, because he had voluntarily filed his bankruptcy petition in California and otherwise taken advantage of California's exemptions. Very simply, the Court held that Hawaii had more contacts to the Trust than California.
The Bankruptcy Trustee tried to argue for the application of an opinion involving offshore trusts, In re Portnoy. [FN6] But the Majority distinguished Portnoy on the basis that it dealt with a self-settled trust where the offshore forum's only interest was to "augment business", and quoted the Portnoy court:
I think it probably goes without saying that it would offend our policies to permit a debtor to shield from creditors all of his assets because ownership is technically held in a self-settled trust, where the settlor/beneficiary nonetheless retains control over the assets and may effectively direct disposition of those assets. [FN7]
The Majority also pointed out that the Portnoy court held that a choice of law "will not be regarded where it would operate to the detriment of strangers to the agreement, such as creditors or lienholders. * * * Portnoy may not unilaterally remove the characterization of property as his simply by incorporating a favorable choice of law provision into a self-settled trust of which he is the primary beneficiary." [FN8]
Because the Trust was not self-settled as to Herbert, California did not have a public policy interest in seeing creditors access a portion of Herbert's interest; in other words, if the Trust had been self-settled, then California would have had such an interest.
Finally, the Majority rejected the Bankruptcy Trustee's argument that distributions from the Trust were property of the estate because they were received within 180 days of the filing of the Bankrutpcy Petition under 11 U.S.C. sec. 541(a)(5)(A). However, this section does not apply to inter vivos trusts, which Sally's Trust was at the time she formed it. The Bankruptcy Trustee on appeal finally made the right argument -- the distributions became property of the Bankruptcy Estate under subsections (6) and (7) of section 541 -- but the Majority held that this argument was too late.
The Dissent
Judge Johnson in his dissent noted that a novel issue was presented to the Court:
No known case (federal, state or otherwise) addresses whether a court sitting in California should enforce Probate Code section 15306.5 against assets in a trust created by an instrument that invokes the trust law of another state or jurisdiction.
But this novel issue, wrote Judge Johnson, fit well into the pattern of what usually happens in similar cases:
However, published cases throughout the country have considered the broader question of whether a court should apply the trust law of a forum state or the trust law of another state designated in a trust instrument. A review of those cases reveals a pattern in which the courts have generally declined to apply the trust law of a foreign jurisdiction selected by the settlor of a trust if doing so would harm creditors or other third parties. In other words, while some courts have applied the trust law of a foreign jurisdiction, they usually do not do so to the detriment of creditors or other third parties. When enforcing a judgment against assets of a trust, courts typically apply the judgment remedies of the forum state when those laws protect creditors more than the law of the other jurisdiction.
Judge Johnson then began to dissect the Majority opinion. Citing to the Restatement as it applied to contracts made little sense, since the creditor was no party to any agreement. And the Majority should have respected the underlying rationale of Portnoy, or as Judge Johnston stated it:
>>> In general, courts typically refrain from applying the trust law of a foreign jurisdiction selected by the settlor of a trust if doing so would harm creditors or other third parties. In most instances, the judgment remedies of the forum state apply.
This carried even greater weight against self-settled trusts:
Regardless of the intent of the settlor, choice of law provisions in trust agreements are not enforced if the law of the forum state prohibits self-settled trusts. If a trust instrument states that the trust is governed by the law of a foreign jurisdiction, that choice of law is not honored if the beneficiary files a bankruptcy case in a different jurisdiction that prohibits self-settled trusts. As a matter of public policy, the laws of the forum state override the choice of law decision by the settlor. It is against public policy to enforce a trust provision from a foreign jurisdiction that would impose this kind of harm upon creditors.
* * *
On appeal, Herbert contends that his mother's trust is not a self-settled trust and, of course, he is correct. But Portnoy, Lawrence, Brooks, Cameron and similar cases establish precedent against enforcing a choice of law provision in a trust instrument if doing so would harm creditors. A settlor of a trust cannot invoke the laws of a foreign jurisdiction to the detriment of creditors or other third parties who are not parties to the trust instrument.
Judge Johnson then surveyed the leading cases relating to contractual agreements to make the point that choice-of-law clauses are usually not enforced to the detriment of creditors who are not party to the agreement. Indeed, as in the surveyed cases, the concept of an "agreement" was largely a farce:
Indeed, no one agreed to anything with Sally. She simply selected a choice of law that she preferred and now Herbert wants to use Sally's choice as a sword (or shield) against Herbert's creditors and the trustee. The California legislature will let her do so but only up to 75%. In that sense, this case presents a conflict between Sally and the California legislature. The latter should prevail.
In particular, decisions interpreting similar New York statutes would compel the conclusion that the local law of the forum state should apply, wrote Judge Johnson.
Particularly as to the Restatement section 187, thought Judge Johnson, the Majority got it wrong. The problem with the choice-of-law provision in the Trust document was that none of the current parties to the lawsuit agreed to it.
Yes, Sally agreed to it, but she's dead. Herbert did not agree to it, nor did Herbert's creditors. The Trust assets were liquid, and Hawaii simply no longer had a significant interest in what happened to the Trust.
By contrast, California has a very strong interest in seeing both that creditors were paid on their judgment and that those who receive income from trusts not be treated better than wage earners who might have 25% of their salaries garnished.
Finally, allowing Herbert to protect his inheritance under Hawaii law while taking advantage of California's exemptions (which are more liberal than Hawaii's) lead to injustice:
Indeed, it would give Herbert the protection of the laws of two states in a manner that neither state contemplated. In effect, Herbert would enjoy the benefits of a new enhanced hybrid legal system.
In that sense, Herbert seeks the benefits of his decision to move to California but not its burdens. Herbert wants the benefits of moving to California (enhanced exemption law) but not its burdens (reduced protection for trusts). But that would elevate Herbert to a status above most citizens of California (who do not benefit from Hawaii trust law) and most citizens of Hawaii (who cannot invoke California exemption laws). When contemplating a choice of law question, the better decision is to apply the law in such a manner that treats people equally to the greatest extent possible. This result not only promotes equality but also personal responsibility.
On that Note, Judge Johnson ended his dissent.
Some Analysis
One lesson of this case relates to the asset protection benefits of revocable trusts -- as to subsequent beneficiaries. While Sally's Trust likely would not have protected her assets from her creditors, here the Trust works to protect the assets for Herbert. The only difference here is the degree of the protection for the distributions -- 100% protection per the Majority, and 75% protection per Judge Johnson.
Never say that "living trusts provide no asset protection" because they can for surviving beneficiaries. This is not to advocate such trusts for asset protection, but rather to note that like so many things they have their uses, and should not be automatically discounted.
A more important lesson is that the law relating choice-of-law and trusts is unsettled as it relates to third-party creditors. While this creates problems for creditors who cannot be sure that the laws of the forum where they are attempting collection will apply, it also creates great uncertainty for planners who are attempting to use trusts for asset protection reasons for their clients.
As both the Majority and Dissent noted, the Courts tend to resolve choice-of-law issues so that creditors and other non-parties to the trust agreement are not disadvantaged. Stated otherwise, the bias is to protect creditors in choice-of-law issues.
This brings us to the real importance of this Opinion, which is how it may affect those who plan with irrevocable self-settled spendthrift trusts for asset protection, a/k/a "asset protection trusts".
While this Opinion did not squarely address the case of an asset protection trust in the traditional context -- this Trust was formed by Sally, not Herbert the Debtor, and started off as being revocable -- the facts as they turned out are close enough that they may be guidance in the future for conflict-of-laws issues relating to asset protection trusts. The case may not be "on all fours" as the saying goes, but it is certainly on all threes."
By the time the case gets to the Court for resolution, we have:
(1) The formerly revocable trust has now become irrevocable because of Sally's death;
(2) The trust was originally self-settled, albeit by Sally and not by Herbert; and
(3) The spendthrift clause is used to protect the trust assets from creditors.
In other words, we didn't start out with an irrevocable self-settled spendthrift trust, but we sort of end up there. This Opinion is as close as we have come so far to a ruling on the choice-of-law issues involving asset protection trusts, outside of the foreign trust context.
Let's forget about Foreign Asset Protection Trusts (FAPTs) for a moment. Instead, let's concentrate on their domestic variant, the Domestic Asset Protection Trust (DAPT), which such states as Delaware, Alaska and Nevada have made popular.
This Opinion is unfavorable for DAPTs, since the Majority and Dissent are in agreement that had the debtor been the settlor/beneficiary, i.e., had the Trust been truly self-settled and been a true DAPT, then the laws of the forum state (California) and not the state where the Trust was formed or where the law had been designated by the Trust document (Hawaii). Both the Majority and Dissent would have recognized California's interest in seeing that creditors were paid, and thus allowed the application of California law.
This is very unfortunate dicta for DAPTs, since the Court basically said that with DAPTs the laws of the forum state where the debtor is located will apply. If this Opinion is followed, it basically means that DAPTs will likely fail to the extent that a settlor/beneficiary/debtor resides outside of the DAPT state or trust assets are found outside of a DAPT state.
In other words, the efficacy of DAPTs may well be limited to persons and assets located in DAPTs. But of course that is not how their sales are being limited.
This is not to be read as any endorsement of Foreign Asset Protection Trusts. As the authors have previously written, FAPTs have repeatedly demonstrated their own serious flaw (the availability of the contempt/incarceration remedy) which is difficult, and in some circumstances impossible, to overcome.
The contrast is that FAPTs do not require favorable choice-of-law rulings to function as intended, since a presumption behind those trusts is that the foreign jurisdiction where the trustee is based is not going to honor U.S. law or court rulings anyway. Those trusts anticipate, in other words, U.S. courts consistently ruling against them in all particulars, and still protecting the assets (whether the Settlor/Debtor may suffer personal consequences such as contempt per the Anderson and Lawrence line of cases is of course another matter completely).
Stated otherwise, if an FAPT fails for some technical reason under domestic law, that does not ipso facto result in creditors getting access to the trust assets -- to the contrary, those assets will still be protected by the foreign law. These choice-of-law issues were already turning out badly for FAPTs as early as 1996 when Portnoy was decided, and the law hasn't improved. FAPTs can ignore this flaw since the offshore forum will always choose the application of its own laws anyway, and without regard to what some U.S. court might do.
FAPT planners will tell you that this issue is a non sequitur, since the foreign court is not going to recognize the domestic decision. Not so with their Domestic sisters. With a DAPT, a failure under domestic law will very likely lead to creditors taking the goods.
Indeed, when Domestic Asset Protection Trusts were first introduced, probably a majority of the (relatively few) asset protection planners thought they were in the nature of a bad joke. There was serious skepticism at that time that the laws of the state where the DAPT was formed would trump for choice-of-law purposes the laws of where the debtor or trust assets were located. This forgotten skepticism increasingly appears to be on the brink of being validated.
Yet, DAPTs have not only persisted but grown in popularity not for any compelling technical legal reasons, but because of aggressive marketing by the trust companies that offer them and other promoters. If this marketing were confined to persons and assets located within a DAPT state, then no choice-of-law issues would arise and the problem would at best be minimal.
The ice starts cracking, however, as DAPTs are marketed and sold persons living outside, and with their assets outside, DAPT states. However, DAPTs have proven to be popular at least with planners, and the number of states with DAPT laws has been steadily expanding. Perhaps this problem will someday care of itself as more and more states adopt DAPT laws, but that someday is not now.
In the meantime, Caveat Emptor; subtitled: "Maybe you should let somebody else's clients be the test pilots." While DAPTs likely work outside bankruptcy[FN9] for persons and assets located within a DAPT state, Zukerkorn provides substantial evidence that the fears of the original skeptics of DAPTs, that they would not "work" outside DAPT states, appear to be well-founded.
At the very least, disclosures of unanswered issues (read: potential problems) regarding DAPTs should be clearly disclosed to clients during the evaluation and planning phase. However, in this author's experience in reviewing many dozens of recent asset protection plans involving DAPTs, these disclosures are not routinely being made.
Probably a "wait and see" attitude towards DAPTs for clients and assets in non-DAPT states is the better course, at least until we can see the areas where they have been proven to work and how their failures can be contained. The author's advice is to consider DAPTs for clients who are resident and have their assets in DAPT states, and to avoid their consideration for all other clients.
But don't just follow the herd -- it may be headed for the cliff.
Citations
In re Zukerkorn, ___ B.R. ____, 2012 WL 6608887 (9th Cir.BAP (Cal.), Dec. 19, 2012). Full Opinion at http://goo.gl/FeACa
FN1. CA Probate Code sec. 15306.5.
FN2. 11 U.S.C. sec. 541(a)(5)(A).
FN3. Restatement (Second) of Conflict of Laws, Introductory Note to Chapter 10.
FN4. Id., at sec. 270, Comment (b).
FN5. Nelson v. Cal.Trust Co., 202 P.2d 1021 (Cal. 1949)..
FN6. In re Portnoy, 201 B.R. 685 (Bk.SDNY, 1996)
FN7. Id., at 700.
FN8. Id., at 701.
FN9. A 2005 revision to the Bankruptcy Code, 11 U.S.C. sec. 548(e), by which Congress specifically targeted DAPTs, throws considerable cold water on the viability of DAPTs in bankruptcy regardless of the state where formed, where the settlor/beneficiary is located, or where the trust assets are located. That statute has similar very negative repercussions for FAPTs.
This article at http://onforb.es/VaTEZK and http://goo.gl/0nWZi
