Self-settled Spendthrift Trusts Move Close to Home

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Sep 2000

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Self-settled spendthrift trusts have gained enormous popularity as an asset-protection tool.<a href="#2" name="2a">2</a> In the past, most
asset-protection schemes required the use of foreign trust law. However, Delaware<a href="#3" name="3a">3</a> and Alaska<a href="#4" name="4a">4</a> recently
enacted legislation that enforces self-settled spendthrift trusts against creditors. As a result of this legislation,
panel trustees and creditors will face the challenge of reaching assets in these trusts when a debtor enters
bankruptcy.

Delaware and Alaska provide only limited relief for certain creditors and panel trustees. The trust may be
attacked as improperly established if the debtor made a procedural error in establishing the trust. In
addition, a panel trustee or creditor may bring a fraudulent conveyance action if the statute of limitations
thereon has not expired, and limited groups of creditors may reach a debtor's trust.<a href="#5" name="5a">5</a> Aside from these
limited exceptions, the best strategy for a creditor or panel trustee facing a self-settled trust is to argue that
the corpus of the trust is property of the bankruptcy estate under §541(a).

Upon the commencement of a bankruptcy case, the debtor's entire interest, whether legal or equitable,
in any property wherever located, becomes part of his bankruptcy estate.<a href="#6" name="6a">6</a> The estate does not include a
debtor's beneficial interest in a trust if the trust is subject to a restriction on the debtor's interest that is
enforceable under "applicable non-bankruptcy law."<a href="#7" name="7a">7</a> Delaware provides that a restriction on transfers in
a Delaware trust instrument is a restriction "that is enforceable under applicable non-bankruptcy law within
the meaning of §541(c)(2) of the Bankruptcy Code."<a href="#8" name="8a">8</a> Although Alaska's statute is silent on the matter,
application of Alaskan law would likely yield the same result. Section 541(c)(2), however, requires that
applicable non-bankruptcy law enforce the restriction on transfers; it does not specify that Delaware or
Alaska law governs the enforceability of the restriction. Consequently, courts will have to determine which
"applicable non-bankruptcy law" determines the validity of the transfer restriction.

Most courts resolve conflict-of-law issues in bankruptcy using the Restatement (Second) Conflict of
Laws.<a href="#9" name="9a">9</a> The "most-significant-relationship" test is the touchstone of this analysis. The Restatement
provides that the law the settlor designates in the trust instrument determines the validity of the trust only
if the designated state has a "substantial relation" to the trust.<a href="#10" name="10a">10</a> Moreover, this designation yields if the
designated law violates "a strong public policy of the state with which, as to the matter at issue, the trust
has its most significant relationship."<a href="#11" name="11a">11</a>

Courts have applied the "most significant relationship" test to foreign self-settled trusts and determined
that the law of the debtor's domicile governs the validity of the trust.<a href="#12" name="12a">12</a> However, no court has addressed
the choice-of-law issue in a case involving a domestic self-settled trust. Decisions involving foreign
self-settled trusts will be helpful in arguing that the trust is property of the estate under §541(a). However,
mere citation to this authority will not be sufficient. Instead, it will be crucial to persuade the court that the
reasoning and policies behind these decisions is sufficiently compelling to warrant application in a case
involving a domestic trust.

The court in In re Portnoy<a href="#13" name="13a">13</a> recognized that a self-settled trust seriously affects the debtor-creditor
relationship and ignored a choice-of-law provision in a debtor's trust instrument. The court then applied
New York law and found that the debtor's trust was property of his estate. In deciding which law to apply,
the court balanced the policy interests of the jurisdictions involved, placing great emphasis on the
debtor-creditor relationship. The court found that the determination of the validity of the trust had its
greatest impact on New York because the debtor lived in New York, a significant number of the debtor's
creditors were in New York, and no creditors had contacts with the "offshore" jurisdiction. The court then
weighed the interests of New Jersey, the situs of the trust, against New York's interests in regulating the
debtor-creditor relationship. Finding that New Jersey's only interest was the generation of business, the
court held that New York's interests were paramount.

Some commentators criticize the court's reasoning in Portnoy and assert that courts should instead apply
the law the settlor designates.<a href="#14" name="14a">14</a> The Portnoy court's reasoning, however, is consistent with settled choice
of law principles. Courts routinely refuse to apply the law designated in an instrument to disputes involving
third parties—including a bankruptcy trustee.<a href="#15" name="15a">15</a> Indeed, enforcing a choice of law provision when a third
party is involved would allow an individual to modify the legal rights of others ex parte.

Moreover, courts have routinely rejected attempts to invoke the laws of a jurisdiction through
formalities. For example, in In re Debolt,<a href="#16" name="16a">16</a> the debtor's spouse obtained a judgment in Ohio granting her
a one-half interest in the debtor's pension. The debtor then moved to Pennsylvania and filed a chapter 13
petition. The couple had lived for a number of years in Ohio, the income contributed to the debtor's trust
was generated in Ohio, and the judgment was entered in Ohio. Noting these interests, the court found that
Ohio had the most significant interest in governing the debtor-creditor relationship that its judgment created.
The bankruptcy court in Ohio is not alone in disregarding formalities and asking which state in fact has the
most significant interest in the debtor-creditor relationship.<a href="#17" name="17a">17</a>

The same reasoning applies to Delaware and Alaska trusts. Delaware or Alaska, whichever the case
may be, clearly has the most significant interest in the administration of trusts located within its borders.
The validity of those trusts as between the debtor and a third party, however, is an entirely separate
matter. As the Portnoy court noted, the latter relationship is solely a debtor-creditor relationship that the
debtor cannot modify ex parte. In the debtor-creditor context, the proper question to ask is: on which
state will the impact of a wrong decision fall? A wrong decision in regulating the debtor-creditor
relationship will generally fall most heavily on the state where the debtor is domiciled.<a href="#18" name="18a">18</a> The Portnoy
court, therefore, was correct in finding that the law of the state where the debtor is domiciled determines
a creditor's ability to reach a trust.<a href="#19" name="19a">19</a>

A debtor may argue that the new Delaware and Alaska legislation is similar to an exemption. Either
state could have achieved the same result by exempting trusts from execution. The technical treatment of
the property under the Bankruptcy Code would differ if the trust was simply exempt, but the debtor would
still ultimately retain the property.<a href="#20" name="20a">20</a> At first blush, the argument seems persuasive. If Texas can provide
a generous homestead exemption,<a href="#21" name="21a">21</a> what is offensive about trust protection? Each seems susceptible to
the same abuse. However, a state's exemptions only apply in bankruptcy when the debtor already has
significant contacts, through domicile, to the exempting state.<a href="#22" name="22a">22</a> A bankruptcy court only applies the
exemptions of one state to impair a creditor's ability to collect a debt determined under the laws of another
state if the debtor has been domiciled in the exempting state. Because of the domicile requirement, the
exempting state already has a substantial interest in regulating the debtor-creditor relationship. The
Delaware and Alaska provisions do not guarantee a minimum level of contacts between the debtor and the
situs of the trust because they have no domicile requirement. Therefore, a per se rule like the one applied
to exemptions is inappropriate.

<h3>Conclusion</h3>

The developments in Delaware and Alaska will increase the availability and use of self-settled trusts.
The unavoidable result is that panel trustees and creditors will face the task of trying to reach these trusts.
State or federal fraudulent conveyance law may be available in some cases. However, when the debtor does
not have significant contacts with the state in which he established the trust, a panel trustee or creditor may
be able to reach the trust through §541(a).

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> The authors thank Prof. Patrick B. Bauer at the University of Iowa for his invaluable contributions to this piece. <a href="#1a">Return to article</a>

<a name="2">2</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…, William C., "Offshore Trust Busting," ABA Journal p.32</a>, November 1999. <a href="#2a">Return to article</a>

<a name="3">3</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…. Code Ann. tit. 12 §§3570-3576 (1998)</a>. <a href="#3a">Return to article</a>

<a name="4">4</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Stat. §34.40.110 (Michie 1998)</a>. <a href="#4a">Return to article</a>

<a name="5">5</a> Any creditor holding a support obligation or property settlement pursuant to an "agreement or order of court" can reach a Delaware trust.

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…. Code Ann. tit. 12 §3573(1)</a>. A pre-transfer tort creditor may also reach the debtor's trust. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…. Code Ann. tit.
12 §3573(2) (1998)</a>. Alaska only allows creditors holding a support judgment to reach a self-settled trust if the debtor was
in default by 30 days or more on the date of the transfer. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Stat. §34.40.110(b)(4)</a>. Alaska provides no exception for
pre-transfer tort creditors. <a href="#5a">Return to article</a>

<a name="6">6</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §541(a) (1994)</a>. <a href="#6a">Return to article</a>

<a name="7">7</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §541(c)(2)(1994)</a>. <a href="#7a">Return to article</a>

<a name="8">8</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…. Code Ann. tit. 12 §3570(9)(c)</a>. <a href="#8a">Return to article</a>

<a name="9">9</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Portnoy, 201 B.R. 685, 698 (Bankr. S.D.N.Y. 1996)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Livingston, 186 B.R. 841, 863
(D. N.J. 1995)</a> (New Jersey law determines director liability where New Jersey has a "compelling interest" in resolving the
dispute); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… and Exchange Commission v. The Infinity Group, 27 F.Supp.2d 559, 564-65 (E.D. Pa. 1998)</a>;

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Kaiser Steel Corp., 87 B.R. 154, 160 (Bankr. D. Colo. 1988)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Morse Tools Inc., 108 B.R.
384, 385-86 (Bankr. D. Mass. 1989)</a>. <a href="#9a">Return to article</a>

<a name="10">10</a> Restatement (Second) Conflict of Laws §270(a) (1971). <a href="#10a">Return to article</a>

<a name="11">11</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; <a href="#11a">Return to article</a>

<a name="12">12</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Brooks, 217 B.R. 98, 101 (Bankr. D. Conn. 1998)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Lawrence, 227 B.R. 907, 916 (Bankr.
S.D. Fla. 1998)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Portnoy, 201 B.R. 685, 700 (Bankr. S.D.N.Y. 1996)</a>. Because these courts follow the
reasoning of the Portnoy court, the piece will focus on the Portnoy decision. <a href="#12a">Return to article</a>

<a name="13">13</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… B.R. 685 (Bankr. S.D.N.Y. 1996)</a>. <a href="#13a">Return to article</a>

<a name="14">14</a> See, e.g., Rubin, Daniel S., and Blattmachr, Jonathan G., "Self-settled Spendthrift Trusts: Should a Few Bad Apples Spoil
the Bunch?" 32 Vand. J. Transn'l L. 763 (1999). <a href="#14a">Return to article</a>

<a name="15">15</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Tandy Computer Leasing, 803 F.2d 391 (8th Cir. 1986)</a> (disregarding choice-of-law provision in lease
when dispute involved third party); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Morse Tool Inc., 108 B.R. 384, 386-87 (Bankr. D. Mass. 1989)</a> (refusing
to enforce choice-of-law provision to a fraudulent conveyance action brought by a bankruptcy trustee because the trustee was not a party to
the contract); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Eagle Enterprises Inc., 223 B.R. 290, 294 (E.D. Pa. 1998)</a>, aff'd. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… B.R. 269
(E.D. Pa. 1999)</a> (ignoring choice of law provision in an agreement where rights of third parties involved). <a href="#15a">Return to article</a>

<a name="16">16</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… B.R. 31, 35 (Bankr. W.D. Pa. 1994)</a>. <a href="#16a">Return to article</a>

<a name="17">17</a> See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Int'l Loan Network Inc., 160 B.R. 1, 16-18 (Bankr. D. D.C. 1993)</a> (disregarding law
of state of incorporation in a fraudulent conveyance action in favor of law where transfer occurred and where corporation had principal place
of business); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Kaiser Steel Corp., 87 B.R. 154, 160 (Bankr. D. Colo. 1988)</a> (applying California law to
fraudulent conveyance action arising from a leveraged buyout where the transaction was approved in California, and a significant number of the
creditors resided in California). <a href="#17a">Return to article</a>

<a name="18">18</a> A system that is too pro-debtor will result in higher costs of borrowing for contract debtors, and a higher rate of uncompensated loss
for tort victims. A system that is too pro-creditor will result in higher costs for social services as debtors become too destitute to afford
the "necessities of life." <a href="#18a">Return to article</a>

<a name="19">19</a> See, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Brooks, 217 B.R. 98, 101-102 (Bankr. D. Conn. 1998)</a>. <a href="#19a">Return to article</a>

<a name="20">20</a> Exempt property becomes property of the debtor's bankruptcy estate, but is then removed from the estate and returned to the debtor. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
U.S.C. §§541(a), 522(b)</a>. <a href="#20a">Return to article</a>

<a name="21">21</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…. Prop. Code Ann. §§41.001</a> and 41.002 (West Supp. 1999) (unlimited value homestead exemption, with area of homestead
limited to one acre for a city lot and either 100 or 200 acres for a farm lot, depending on whether the debtor is single or
married). <a href="#21a">Return to article</a>

<a name="22">22</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §522</a>(b)(2)(A). <a href="#22a">Return to article</a>

Journal Authors

Matthew T. Cronin

Thomas L. Flynn

Journal Date

Friday, September 1, 2000 - 12:00