Spendthrift Trusts The Real (but Not Unlimited) Benefits in Bankruptcy

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Oct 2003

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Under California law, the assets contained in a valid spendthrift trust are generally
protected from the reach of the beneficiary's creditors. Further, in the
event a beneficiary under a valid spendthrift trust files for bankruptcy, the
trust assets will not become part of the beneficiary's bankruptcy estate
and, accordingly, will not be administered and liquidated by the
beneficiary's bankruptcy trustee.

An individual filing a
bankruptcy petition is entitled to retain certain minimal, exempt property.
This exempt property is outside of the reach of the individual's
bankruptcy trustee and creditors. Further, certain property rights, such as a
beneficiary's interest in a valid spendthrift trust, that do not become
part of the individual's bankruptcy estate may be retained by the
individual free and clear of creditors' claims and the reach of the
individual's bankruptcy trustee and outside the scope of the severe
limitations imposed on exempt property. The availability and extent of
spendthrift trust protection is determined by state law.

<h3>California Spendthrift Trust Law</h3>

California
law recognizes the validity of spendthrift trusts. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=C…
Probate Code §§15300</a> and 15301 specify that if a trust provides
the beneficiary's interest in income or principal is not subject to voluntary
or involuntary transfer (i.e., a
"spendthrift trust"), the beneficiary's interest in such a
trust's income or principal is not subject to enforcement of a money
judgment until paid to the beneficiary. The exceptions to this general rule are
set out in <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=C…
Probate Code §§15304 through 15307. Section 15304</a> provides
that a settlor may not create a spendthrift trust for himself or herself. That
is, a settlor of a spendthrift trust cannot simultaneously be a beneficiary of
the same spendthrift trust under California law. The policy against the
so-called "self-settled" trust voided by California law is to
prevent an individual from placing his or her property beyond the reach of
creditors while still enjoying the use and benefits of such property. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Moses, 167 F.3d at 473</a>.

<a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=C…
Probate Code §§15305, 15305.5</a> and 15306 provide exceptions to the
general spendthrift trust protection from creditors under very specific
circumstances. Probate Code §15305 pertains to money judgments for support
of a beneficiary's spouse, former spouse or minor children. Probate Code
§15305.5 pertains to restitution for crime victims or for damages incurred
as a result of contact for which the defendant beneficiary was convicted of a
felony. Section 15306 permits governmental entities in certain circumstances to
obtain reimbursement for public support furnished to a beneficiary or
beneficiary's family.

<blockquote><blockquote>
<hr>
<big><center>
There
is a strong congressional intent underlying the Bankruptcy Code to protect
spendthrift trusts and to exclude assets in such trusts from a bankruptcy
estate.
</center></big>
<hr>
</blockquote></blockquote>

Under
Probate Code §15306.5, a creditor may obtain an order directing the
trustee of a spendthrift trust to satisfy all or part of a judgment out of the
payment to which the beneficiary is entitled under the trust instrument so long
as the payment does not exceed 25 percent of the payment that otherwise would
be made to the beneficiary and is not necessary for support of the beneficiary
or dependents of the beneficiary. The relevance of §15306.5 is that it
removes 25 percent of the debtor's interest in the trust from traditional
spendthrift trust status to the extent not necessary for support of the
beneficiary and all the persons the beneficiary is required to support. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
re Newton, 922 F.2d 1379 (9th Cir. 1990)</a>.

Probate
Code §15307 permits a judgment creditor to execute against a
beneficiary's interest in a spendthrift trust for "any amount to
which the beneficiary is entitled under the trust instrument or that the trustee,
in the exercise of trustee's discretion, has determined to pay the
beneficiary in excess of the amount that is or will be necessary for the
education and support of the beneficiary...." To obtain relief under
§15307, a judgment creditor must file a petition under §709.010 of
the California Code of Civil Procedure, and the court may make a continuing
order for application for future payments to the satisfaction of the judgment.
However, the creditor does not have the power to compel the trustee to exercise
discretion.

The
critical inquiry in determining whether a spendthrift trust is valid under
California law is whether the trust's beneficiaries exercise excessive
control over the trust. A beneficiary cannot exercise such control and thereby
shield the trust with an anti-alienation provision lacking true substance. The
purpose of a spendthrift trust is to protect a beneficiary from himself or
herself and his or her creditors. In bankruptcy cases, the debtor's
degree of control over the spendthrift trust is often the primary consideration
in determining its validity. It is clear that, if a beneficiary under a
spendthrift trust has absolute and sole discretion to compel distribution of
the trust assets, the spendthrift provision must fail. When spendthrift trusts
are shams or otherwise void, the trust property is included in the bankruptcy
estate.

<h3>Property of the Estate</h3>

When a bankruptcy petition is filed, an estate is created consisting of "all
legal or equitable interests of the debtor in property as of the commencement
of the case." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
U.S.C. §541(a)</a>. The Bankruptcy Code, however, excludes from property
of the estate "any interest in a plan or trust that contains a transfer
restriction enforceable under relevant non-bankruptcy law." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
U.S.C. §541(c)(2)</a>; see, also, <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… v. Shumate, 112 S.Ct. 2242 (1992)</a>.
More specifically, Bankruptcy Code §541(c)(2) provides that "[a]
restriction on the transfer of a beneficial interest of the debtor in a trust
that is enforceable under applicable non-bankruptcy law is enforceable
in" a bankruptcy case. There is a strong congressional intent underlying
the Bankruptcy Code to protect spendthrift trusts and to exclude assets in such
trusts from a bankruptcy estate. The Ninth Circuit Court of Appeals has held
that a valid spendthrift trust created under state law is excluded from a
bankruptcy estate pursuant to §541(c)(2). See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Moses, 167 F.3d 470 (9th Cir. 1999)</a>.

<h3>Fraudulent Transfers</h3>

The
bankruptcy estate representative (the trustee) has the power to recover for the
benefit of the debtor's creditors certain transfers made by the debtor
prior to bankruptcy. Bankruptcy Code §548 allows the trustee to avoid and
recover transfers made within one year prior to the bankruptcy with intent to
hinder, delay or defraud creditors or made by an insolvent debtor for less than
reasonably equivalent value. Further, Bankruptcy Code §544 empowers the
trustee to avoid and recover transfers that are recoverable by an existing
unsecured creditor under state law. For example, because a bankruptcy trustee
enjoys the power of a hypothetical judgment creditor, the trustee can utilize <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=C…
Probate Code §15306.5</a> to remove 25 percent of the debtor's
interest in a valid spendthrift trust from traditional spendthrift status so
long as that amount is not determined by the court to be necessary for the
support of the beneficiary or the beneficiary's dependents. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
re Neuton, 922 F.2d 1379</a>.

Under
the Uniform Fraudulent Transfer Act, a transfer to a trust established to
defraud the settlor's creditors is void. Abuse of a trust by a settlor,
such as using a purported spendthrift trust as a private bank account, is
evidence of intent to defraud creditors and therefore supports setting aside
the trust and allowing the settlor's creditors to reach the trust res.
See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1….
v. Lawrence, 189 F.3d 838, 845 (9th Cir. 1999)</a>.
In determining fraudulent intent, the courts look to badges (or elements) of
fraud such as (1) inadequacy of consideration involved in the transfer, (2) the
closeness of the relationship between the transferor and transferee, (3) the
transferor's insolvency as a result of the transfer, (4) whether or not
the transfer was in the ordinary course, (5) the transferor's retention
of control following the transfer and/or (6) the timing/hasty nature of the
transfer.

<h3>Offshore and Asset-protection Trusts</h3>

Offshore
trusts and asset-protection trusts may be used to attempt to place assets
beyond the reach of creditors and a bankruptcy trustee. However, even assuming
that the establishment of the trust did not constitute a fraudulent transfer,
under the Bankruptcy Code's broad definition of the bankruptcy estate,
certain assets placed in an offshore trust or in an asset-protection trust may
nevertheless be held to be the assets of the bankruptcy estate and subject to
the bankruptcy court's jurisdiction. A U.S. Bankruptcy Court may simply
refuse to allow laws of foreign jurisdictions or states to control if it finds
that such laws are repugnant to public policy. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Brooks, 217 B.R. 98 (Bankr. D. Conn. 1998)</a>.

Since
1997, two states—Alaska and Delaware—have been in competition for
asset-protection trusts. The laws in those states provide certain spendthrift
protection to self-settled trusts. However, courts in states that are hostile
to self-settled spendthrift trusts are unlikely to enforce spendthrift trust
provisions in self-settled asset-protection trusts regardless of the effect
that those provisions might have under the law of the trust situs. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Portnoy, 201 B.R. 685 (Bankr. S.D.N.Y. 1996)</a>;

<a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Brooks, 217 B.R. 98 (Bankr. D. Conn. 1998)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Lawrence, 227 B.R. 907 (Bankr. S.D. Fla. 1998)</a>. Moreover, the nationwide jurisdiction of federal
bankruptcy courts operates as a check on the power of states to export
asset-protection trust legislation. This diminishes the utility of Delaware and
Alaska asset-protection trusts since a federal bankruptcy court, unlike a state
court, has the power to directly reach a debtor's assets throughout the
United States. While a U.S. Bankruptcy Court does not have power in foreign
jurisdictions, it does have the power to deny a debtor trust settlor a
discharge (obtaining a discharge is generally the primary goal of an individual
debtor when filing bankruptcy). Accordingly, the U.S. Bankruptcy Court can
exert substantial leverage over a debtor even with regard to an offshore trust
that cannot be reached by a U.S. court.

Journal Authors

David S. Kupetz

Journal Date

Wednesday, October 1, 2003 - 12:00

Bankruptcy Rule

2003