A.   Domestic Asset Protection Trusts

 

A properly drafted trust, incorporating the pointers from the discussion above, may be an insurmountable obstacle to creditors; provided that the trust is for the benefit of a third-party beneficiary.[1]  Most asset protection clients are looking to protect their own assets and are usually not beneficiaries of existing trusts.  Consequently, the majority of asset protection trusts are self-settled.  Because California strips the spendthrift protection of a self-settled trust, practitioners must look to other jurisdictions.

           

Several U. S. jurisdictions now allow self-settled trusts to afford their settlors the protection of the spendthrift clause.  Alaska was the first jurisdiction to enact such laws in 1997[2] and was shortly followed by Delaware,[3] Nevada[4] and a few others.[5]   All of these domestic self-settled asset protection trusts shall be referred to as “DAPTs.”

           

Using Delaware as sample DAPT jurisdiction, a Delaware DAPT must comply with the following requirements: (i) the trust must be irrevocable and spendthrift; (ii) at least one Delaware resident trustee must be appointed; (iii) some administration of the trust must be conducted in Delaware; and (iv) the settlor cannot act as a trustee.[6]

           

The DAPT jurisdictions appear to be a simple solution for a settlor of a self-settled trust seeking asset protection if the settlor is a resident of a DAPT jurisdiction and has assets in the jurisdiction.  California residents with California assets may not be able to reap the asset protection benefits of these trusts.

 

1.                 The Risks of DAPTs

a.     Conflict of Law

 

Trusts are generally governed by the laws of the jurisdiction that is designated by the settlor as the governing jurisdiction.[7]  There are two exceptions to the general rule: (i) states will not recognize laws of sister states that violate their own public policy,[8] and (ii) if the trust owns real property, such property will be governed by the law of jurisdiction that is the property’s situs.[9]

           

In determining whether a law of another state would be enforceable in California, the court would analyze whether the law of the other state is contrary to a fundamental policy of California, and would then determine whether California has a “materially greater interest” than the other state in adjudicating the issue.[10]

           

To date, there are no California (or any non-DAPT jurisdiction) cases dealing with the protectiveness of DAPTs.  It is possible that if a case involving a DAPT was litigated in California, the California court may not recognize the law of the DAPT jurisdiction and refuse to extend the spendthrift protection to a self-settled trust.

           

If a DAPT owns California real property, then California law will govern any collection action applicable to the real property and the spendthrift protection of the DAPT jurisdiction will be inapplicable.[11]  This problem may be remedied to some extent by having a DAPT own California real estate through a limited liability company or a limited partnership organized under the laws of the DAPT jurisdiction.  This way the trust no longer owns California realty, but owns an intangible governed by the laws of the DAPT jurisdiction.[12]

 

b.     The Full Faith and Credit Clause

 

The Full Faith and Credit clause of the Constitution provides that each state has to give full faith and credit to the laws of every other state.[13]  This means that if a California court refuses to recognize the protection of a DAPT and enters a judgment for the creditor, the creditor may be able to enforce the judgment against the trustee of the DAPT, even if that trustee was located in the DAPT jurisdiction.

 

However, even under the Full Faith and Credit clause the states are not required to recognize the laws of sister states that are contrary to their own public policy.[14]  Consequently, a DAPT jurisdiction court may refuse to enforce a California judgment because it was entered under trust laws substantially different to those of the DAPT jurisdiction.

 

At this point the analysis becomes quite circular.  A creditor argues in California court that the court should apply California law and not Alaska law to an Alaska trust because Alaska trust law violates California public policy against self-settled trusts.  In turn, Alaska refuses to recognize the California judgment because it violates Alaska public policy in protecting self-settled trusts.

 

This analysis should lead the practitioner to one inescapable conclusion.  Until the application of the Full Faith and Credit clause is litigated in the context of a self-settled trust, the risk is too great that a DAPT would not afford the debtor with the required protection.

 

2.                 Foreign Trusts – The Superior Alternative

 

Foreign trusts are discussed in a lot more detail below.  This section will simply point out the various aspects that make a foreign trust more advantageous than a DAPT.

 

The term “foreign trust” usually means a trust that states that it should be interpreted under the laws of a foreign jurisdiction.  This means that the laws of the foreign jurisdiction will apply to the trust and the enforceability of the trust’s spendthrift clause.  What advantages does that carry?

 

All foreign jurisdictions that compete in the asset protection market allow self-settled trusts to be an effective shield against creditors.  This is similar to the U. S. DAPT jurisdictions that have now gone the same route.

 

However, foreign trusts are not subject to the Full Faith and Credit clause or the Supremacy Clause.  This means that with a foreign trust there is never any doubt that the favorable law of the foreign jurisdiction will be applied to the trust, and there is also no doubt that the foreign jurisdiction does not have to enforce any judgment coming out of a U. S. state (whereas a sister state may have to recognize such a judgment).

 

However, even setting aside this uncertainty, foreign trusts are vastly superior to the Alaska-type trusts.  For example, the foreign asset protection jurisdictions provide that the creditor has the burden of proving a fraudulent conveyance.  More importantly, the creditor’s burden of proof is the criminal standard of “beyond a reasonable doubt.”

 

In foreign jurisdictions the statute of limitations on bringing a fraudulent conveyance action is not only short, but it also begins running on the date of the transfer, not the date the transfer is “discovered.” 

 

Finally, while not a legal deterrent, the costs associated with challenging a foreign trust prove to be an insurmountable obstacle to most creditors.  It also surprises many that foreign trusts are usually less expensive to set up and administer than DAPTs.

 


[1] The protective benefits of a trust may also be lost pursuant to a fraudulent transfer challenge.  Civil Code §§ 3439-3439.12.  A discussion of fraudulent transfers is beyond the scope of this article.

[2] Alaska Statutes § 34.40.110.

[3] 12 Del. Code § 3572 (Qualified Dispositions in Trust Act).

[4] Nev. Rev. Stat. ch. 166.

[5] Mo. Ann. Stat. § 428.005 et. seq.; R.I. Gen. Laws §§ 18-9.2.  Oklahoma allows revocable self-settled trusts, and prevents creditors from forcing the settlor to exercise his power to revoke.  31 Okla. Stat. Ann. §§ 13, 16.

[6] 12 Del. Code § 3570.

[7] Rest. 2d Conf. of Laws § 273(b); Uniform Trust Law § 107(1).

[8] Washington Mutual Bank v. Superior Court (2001) 24 Cal.4th 906, 916-917; Rest. 2d Conf. of Laws § 187, subd. (2); Uniform Trust Law § 107(1).

[9] Rest. 2d Conf. of Laws § 280.

[10] Washington Mutual Bank at 916.

[11] Rest. 2d Conf. of Laws § 280.

[12] Corporations Code §§ 15691, 17450(a).

[13] U.S. Const., Art. IV, § 1.

[14] Nevada v. Hall (1978) 440 U.S. 410, 424.