Self-Settled Spendthrift Trusts: Should a Few Bad Apples Spoil the Bunch?
By Gideon Rothschild, Daniel S. Rubin and Jonathan G. Blattmachr
This article originally appeared in the November/December 1999 issue of the Journal of Bankruptcy Law & Practice (Vol. 9, No. 1).
This article originally appeared in the November/December 1999 issue of the Journal of Bankruptcy Law & Practice (Vol. 9, No. 1).
The bankruptcy court's recent attempts to apply conflict of laws principles to spendthrift trusts seem to substantiate the old adage that bad facts produce bad law. Citing public policy concerns, the bankruptcy courts in two recent decisions in this area, In re Portnoy(1) and In re Brooks,(2) each applied the law of the forum state, rather than that designated under the trust instrument, in order to avoid finding that "applicable non-bankruptcy law" exempted a self-settled(3) spendthrift trust from the bankruptcy estate under Bankruptcy Code section 541(c)(2).(4) Although each of the debtors in Portnoy and Brooks appeared to have created the trusts primarily to avoid creditors' claims,(5) neither the Portnoy court nor the Brooks court even attempted to distinguish the substantial authority providing that a settlor's designation of controlling law is generally to be respected by the courts.(6) Although the results in Portnoy and Brooks may have been appropriate to their immediate facts, the purported common rationale for their holdings nevertheless does a disservice to the generally thoughtful and considered body of law in this area. These decisions set an unfortunately biased precedent for future debtors who may be more deserving of relief.(7) This Article will attempt to elucidate that broader body of conflict of laws principles and to apply those principles to spendthrift trusts and the Bankruptcy Code § 541(c)(2) exemption in a more objective manner than may have been possible under the presumably egregious factual backgrounds of Portnoy and Brooks.(8)
Background
The conflict of laws issue in both Portnoy and Brooks seems to have turned on a single defining feature: the settlors' designation of the laws of "offshore" jurisdictions, specifically, Bermuda and the Jersey Channel Islands, in an effort to obtain spendthrift protections for the settlors' retained beneficial trust interests at a time when the settlors were apparently experiencing significant creditor problems.(9) The settlors' decision to go offshore was presumably driven by the fact that at the time the Portnoy and Brooks trusts were created, most domestic jurisdictions (including the respective forum states) did not permit a self-settled trust to effectively shield a settlor's retained beneficial interest from his or her creditors.(10) This is in contrast to the generally permissive state of domestic law permitting effective restraints on the alienation of non-settlor beneficiaries' trust interests. With respect to those interests, courts throughout the United States have for the past hundred and twenty years applied the maxim "cujus est dare, ejus est disponere," or "[w]hose it is to give, his it is to dispose."(11)
The Portnoy court chose the rule of the Restatement (Second) of Conflict of Laws section 270 to resolve the conflict between the law of the Jersey Channel Islands and the law of the respective forum state.(12) Section 270 provides that:
An inter vivos trust of interests in movables is valid if valid
(a) under the local law of the state designated by the settlor to govern the validity of the trust, provided . . . that the application of its 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 under the principles stated in [RESTATEMENT (SECOND) OF CONFLICT OF LAWS] § 6. . . (13)
The Portnoy court also cited New York law, and recognized that, under this law, "to render foreign law unenforceable as contrary to public policy, it must violate some fundamental principal of justice, some prevalent conception of good morals, or some deep-rooted tradition of the common wealth."(14)
The Portnoy and Brooks courts then discussed precedent that held self-settled spendthrift trusts to be contrary to public policy under the law of their respective forum states(15). Each court thus determined to decide whether the trust was valid using the subjective criteria set forth in section 6 of the Re-statement (Second) Conflict of Laws which provides that "[a] court, subject to constitutional restrictions, will follow a statutory directive of its own state on choice of law," or, if none, the court should determine choice of law based on
a) the needs of the interstate and international systems,
b) the relevant policies of the forum,
c) the relevant policies of other interested states and the relative interests of those states in the determination of the particular issue,
d) the protection of justified expectations,
e) the basic policies underlying the particular field of law,
f) certainty, predictability and uniformity of result, and
g) ease in the determination and application of the law to be applied.(16)
Under this analysis, the courts in both cases held that the domestic jurisdiction had a greater interest in the matter at issue than did the foreign jurisdiction.(17) The blanket rule that may be distilled from these cases seems to be that, unlike with other spendthrift trusts, public policy acts as an absolute bar to an individual's right to create an effective self-settled spendthrift trust unless the law of the forum state permits such trusts.
The Portnoy court chose the rule of the Restatement (Second) of Conflict of Laws section 270 to resolve the conflict between the law of the Jersey Channel Islands and the law of the respective forum state.(12) Section 270 provides that:
An inter vivos trust of interests in movables is valid if valid
(a) under the local law of the state designated by the settlor to govern the validity of the trust, provided . . . that the application of its 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 under the principles stated in [RESTATEMENT (SECOND) OF CONFLICT OF LAWS] § 6. . . (13)
The Portnoy court also cited New York law, and recognized that, under this law, "to render foreign law unenforceable as contrary to public policy, it must violate some fundamental principal of justice, some prevalent conception of good morals, or some deep-rooted tradition of the common wealth."(14)
The Portnoy and Brooks courts then discussed precedent that held self-settled spendthrift trusts to be contrary to public policy under the law of their respective forum states(15). Each court thus determined to decide whether the trust was valid using the subjective criteria set forth in section 6 of the Re-statement (Second) Conflict of Laws which provides that "[a] court, subject to constitutional restrictions, will follow a statutory directive of its own state on choice of law," or, if none, the court should determine choice of law based on
a) the needs of the interstate and international systems,
b) the relevant policies of the forum,
c) the relevant policies of other interested states and the relative interests of those states in the determination of the particular issue,
d) the protection of justified expectations,
e) the basic policies underlying the particular field of law,
f) certainty, predictability and uniformity of result, and
g) ease in the determination and application of the law to be applied.(16)
Under this analysis, the courts in both cases held that the domestic jurisdiction had a greater interest in the matter at issue than did the foreign jurisdiction.(17) The blanket rule that may be distilled from these cases seems to be that, unlike with other spendthrift trusts, public policy acts as an absolute bar to an individual's right to create an effective self-settled spendthrift trust unless the law of the forum state permits such trusts.
Discussion
Putting aside the subjective consideration of public policy, the law is well established that a settlor's designation of controlling law governs the administration of a trust, including the efficacy of a trust's spendthrift provision:
If the settlor creates a trust to be administered in a state other than that of his domicil, the law of the state of the place of administration, rather than that of his domicil, ordinarily is applicable. Thus a settlor domiciled in one state may create an inter vivos trust by conveying property to a trust company of another state as trustee and delivering the property to it to be administered in that state. In that case the law of that state will be applicable as to the rights of creditors to reach the beneficiary's interest.
This permits a person who is domiciled in a state in which restraints on alienation are not permitted, to create an inter vivos trust in another state where they are permitted and thereby take advantage of the law of the latter state.(18)
In fact, in some jurisdictions a settlor's ability to designate the law of a particular jurisdiction as the governing law of the trust is expressly provided by statute. For example, Section 7-1.10 of the New York Estates, Powers and Trusts Law provides that "[w]henever a person, not domiciled in this state, creates a trust which provides that it shall be governed by the laws of this state, such provision shall be given effect in determining the validity, effect and interpretation of the disposition in such trust. . . ."(19) Interpreting a prior version of this statute, the New York Court of Appeals in Hutchinson v. Ross stated that "[t]he statute makes [a settlor's] express declaration of intention [of controlling law] conclusive. . . ."(20) A New York Court also noted that "[i]t cannot be doubted . . . that this state encourages the selection by residents of other states of New York as the situs of trusts."(21) Although the prima facie ability of a domiciliary settlor to create a valid trust governed by the laws of a foreign jurisdiction is not expressly conferred by statute, it is either set forth under existing case law or can be logically inferred.(22) A strong argument can also be made that principles of judicial comity require that a settlor's designation of controlling law be respected by the courts.(23)
The apparent conflict over the import of Section 270 of the Restatement (Second) of Conflict of Laws, as set forth in Portnoy and Brooks and the foregoing authorities is a result of the fact that section 270 is specific to the validity of a trust rather than the efficacy of a purported restraint on alienation of beneficial trust interests. With regard to the conflict of laws issue on this latter matter, section 273 of the Restatement (Second) of Conflict of Laws is the applicable authority. Section 273 provides that:
Whether the interest of a beneficiary of [an inter-vivos] trust of movables is assignable by him and can be reached by his creditors is determined . . .
. . . by the local law of the state, if any, in which the settlor has manifested an intention that the trust is to be administered, and otherwise by the local law of the state to which the administration of the trust is most substantially related.(24)
The express public policy caveat of section 270 is neither repeated in section 273 nor in the official comment.(25) The absence of such a caveat raises the question of whether public policy is an appropriate basis for effectively overturning a settlor's designation of controlling law when the issue is the alienation of spendthrift trust interests rather than the general validity of the trust. Although it cannot be denied that public policy concerns underlie the application of all conflict of laws principles, the express public policy provision in section 270 makes its absence from section 273 conspicuous and suggestive of a relatively low importance vis á vis the application of conflict of laws principles to spendthrift trusts.
Indeed, even the Portnoy and Brooks courts acknowledged that a settlor may generally specify the trust's controlling law.(26) For this reason, each court most likely misconstrued the question before it as one of validity under section 270, rather than administration and efficacy of the spendthrift provision under section 273. Moreover, even under section 270, each court simply chose to assume the premise that it wished to prove; that is, the law of the forum should govern because it provides that self-settled trusts are void as to the settlor's creditors.(27) Such reasoning, however, constitutes an obvious nonsequitor. Although application of the foreign law may, arguendo, have violated a strong public policy of the forum, such a finding cannot deliver the courts' desired result unless it is also the case that "as to the matter at issue, the trust has its most significant relationship" to the forum.(28)
On this latter point, although the principles contained in section 6 of the Restatement (Second) of Conflict of Laws, recited above, are quite general, it seems questionable whether, as to the matter at issue, the Portnoy and Brooks trusts would have their most significant relationship with the forum state. This issue would most likely turn on the location of the primary administration of the trust.(29) For example, a trust designates the law of the Jersey Channel Islands as controlling, and the trustee resides in the Jersey Channel Islands with the vast majority of trust transactions taking place in the Jersey Channel Islands, but the trust settlor is a resident somewhere in the United States. It would appear that a domestic creditor, with a cause of action against the trust settlor, would be hard pressed to argue that the United States has a more significant relationship with the trust as to that cause of action than the Jersey Channel Islands. Aside from the cases dealing with self-settled trusts, there seems to be no authority suggesting that a court can refuse to apply the law declared by the trust settlor simply because the debtor/beneficiary resides in the forum state.(30) Although the public policy concerns of the forum state may well differ when the trust is self-settled, focusing on self-settlement begs the applicable question: "as to the matter at issue," which state has the most significant relationship to the trust?
Moreover, in contrast to the implication of Portnoy and Brooks, the fact that the forum state does not permit self-settled spendthrift trusts to be created under its own law does not necessarily mean that it would violate a strong public policy of the forum state to recognize a self-settled spendthrift trust if it was validly created under the law of a foreign jurisdiction. In fact,
"[i]t would seem that the policy of a state, whether it be to restrain alienation in order to protect the beneficiary, or to permit alienation in order to protect creditors and assignees, is not so strong as to preclude the application of the law to the contrary prevailing in another state."(31)
Although not dealing with the efficacy of a restraint on alienation of a self-settled spendthrift trust interest, the Fifth Circuit stated that:
Mere difference between the law of the forum and that of the foreign State does not of itself prevent enforcement of the foreign law or rights based thereon if such law is not against the public policy of the forum. The fact, therefore, that under Florida law the trust agreement is presumptively void does not prevent a Florida court from applying the law of Minnesota, where the agreement was made and under which law the agreement is presumptively valid. Such difference in the law of Florida and that of Minnesota does not of itself prevent enforcement in Florida of the Minnesota contract and the rights based thereon, since the difference is not contrary to the prohibitory law of that forum.(32)
In addition, in every case where the enforcement of the law of another jurisdiction appears contrary to the public policy of the forum state, principles of judicial comity provide a counterbalancing public policy that the validity of the law of such other jurisdiction be enforced.(33)
There are also a number of cases that have applied conflicts of law principles to spendthrift trusts without resort to public policy. For example, though not considered in either the Portnoy or Brooks opinions, the bankruptcy court's decision in Togut v. Hecht seems to provide direct precedent for both cases.(34) At issue in Togut was ". . . whether the laws of the State of Maryland or New York are applicable in determining the validity of the spendthrift trust provisions. . . "(35) In Togut, the debtor argued for the application of Maryland law, because it would preclude the bankruptcy trustee from claiming any portion of the spendthrift trust's undistributed income and principal as a part of the bankruptcy estate.(36) The bankruptcy trustee argued that the law of the forum state of New York should apply, because under the law of New York, the bankruptcy trustee would be entitled to ten percent of the trust's undistributed income as well as any portion of the remaining ninety percent of such income that might be in excess of the debtor's reasonable living requirements.(37) The bankruptcy court's determination that the law of Maryland was the "applicable non-bankruptcy law" for purposes of determining the Bankruptcy Code section 541(c)(2) exemption(38) was based solely upon the trust settlor's designation of Maryland law as the law governing "all questions pertaining to [the trust's] validity, construction and administration."(39) The court apparently did not consider the possibility that the application of the more broadly based Maryland spendthrift laws might offend the public policy concerns of the bankruptcy court's forum of New York. The Bankruptcy Court's decision in Togut is, therefore, difficult to reconcile with Portnoy and Brooks, as all three cases dealt with the application of conflict of laws principles to the spendthrift trust exemption under section 541(c)(2).(40) It is especially difficult to reconcile Portnoy and Togut since both cases were decided in a New York forum that presumably had the same public policy in Portnoy that it did a mere nine years earlier in Togut.
Of the cases outside the bankruptcy area concerning the application of conflict of laws principles to spendthrift trusts, many respect the settlor's express designation of controlling law, notwithstanding that such a result seems to frustrate public policy concerns at least as important as the protection of creditors' rights. Most telling, perhaps, are those cases that deal either with a spousal right of election or the rights of parties in marital contests, as both types of cases implicate a substantial public policy recognized in all states. For example, in The National Shawmut Bank of Boston v. Cumming,(41) the settlor, a domiciliary of Vermont, created a trust of "the greater part of his property," which trust the settlor designated to be "construed and the provisions thereof interpreted under and in accordance with the laws of the Commonwealth of Massachusetts."(42) As recognized by the lower court's opinion, the Shawmut settlor's clearly implied intent in designating Massachusetts law as controlling, was to defeat his surviving spouse's significantly greater inheritance rights under Vermont law.(43) According to the Shawmut court:
[i]f the settlor had been domiciled in this Commonwealth and had transferred here personal property here to a trustee here for administration here, the transfer would have been valid even if his sole purpose had been to deprive his wife of any portion of it. The Vermont law we understand to be otherwise and to invalidate a transfer made there by one domiciled there of personal property there, if made with an actual, as distinguished from an implied, fraudulent intent to disinherit his spouse.(44)
In holding that Massachusetts law should apply, thereby depriving the surviving spouse of the greater part of her inheritance rights, the Shawmut court stated that "[t]he general tendency of authorities elsewhere is away from the adoption of the law of the settlor's domicil where the property, the domicil and place of business of the trustee, and the place of administration intended by the settlor are in another State."(45)
If the courts, nevertheless, insist upon a general public policy review whenever a self-settled spendthrift trust comes within their purview, their natural impulse towards automatic reliance on precedent must be tempered by recognition that our society has changed significantly since the Restatement (Second) of Conflict of Laws took its snap-shot of the law more than 40 years ago. It is a truism that notions of public policy are not static, but vary with time and place, and courts are obliged to revisit public policy if they choose to cite to it as a judicial check against otherwise permissible estate and asset protection planning opportunities. In this regard, it was not until the United States Supreme Court decided Nichols v. Eaton(46) in 1875 that the general validity of spendthrift trusts, which today we take for granted in this country, was first recognized throughout the United States. In Nichols the court broke with a long tradition of English common law on spendthrift trusts, which to this day invalidates spendthrift trust protections in that country:
We concede that there are limitations which public policy or general statutes impose upon all dispositions of property, such as those designed to prevent perpetuities and accumulations of real estate . . . . We also admit that there is a just and sound policy . . . to protect creditors against frauds upon their rights. . . . But the doctrine, that the owner of property . . . cannot so dispose of it, but that the object of his bounty . . . must hold it subject to the debts due his creditors . . . is one which we are not prepared to announce as the doctrine of this court.(47)
Another example of the vagaries of public policy over time is the recent spate of legislative negation of the Rule Against Perpetuities in this country. When Nichols v. Eaton was decided in 1875, the Rule Against Perpetuities was viewed as a necessary limitation on potential restraints on the alienability of property. Today, eleven states have repealed the Rule Against Perpetuities and a number of additional states are considering such changes.(48) Therefore, while on the one hand it may be argued there has been an erosion of the protections offered by spendthrift trusts in this country,(49) on the other hand it can be said that spendthrift trust protections are expanding.(50) In the aggregate these developments simply evidence the public policy pendulum swinging in different directions in response to the social and economic needs of our changing society.
Bankruptcy courts, however, have failed to take judicial notice of the recent trend of domestic jurisdictions to validate self-settled spendthrift trusts, both legislatively and judicially, provided the circumstances surrounding settlement are not deemed inequitable.(51)
In addition, although it cannot be considered part of this recent trend since it was initially enacted in 1861, in line with the foregoing is Colorado Revised Statutes section 38-10-111, which provides that "[a]ll deeds of gift, all conveyances, and all transfers or assignments, verbal or written, of goods, chattels, or things in action, or real property, made in trust for the use of the person making the same shall be void as against the creditors existing of such person"(52) Caselaw has settled the Colorado statute's obvious logical interpretation that as to future creditors, a self-settled Colorado spendthrift trust will be effective to protect the settlor's retained beneficial interest.(53)
Even New York, where the Portnoy court found the notion of a self-settled spendthrift trust to be offensive, has taken a step towards the recognition of such trusts under the appropriate circumstances. In Matter of Heller, an apparent case of first impression, the New York Surrogate's Court permitted the severance of "an irrevocable inter-vivos trust into two trusts for the novel purpose of insulating the trust's substantial cash and securities from potential creditor's claims that could arise from the trust's real property."(54) The severance of the trust into two portions, in effect, caused the creation of a self-settled spendthrift trust vis á vis the existing trust. In allowing this self-settled spendthrift trust to be created, the Heller court rightfully acknowledged that
New York law recognizes the right of individuals to arrange their affairs so as to limit their liability to creditors, including the holding of assets in corporate form, making irrevocable transfers of their assets, outright or in trust, as long as such transfers are not in fraud of existing creditors, establishing spendthrift trusts to protect the assets from the beneficiary's creditors and renouncing property interests that otherwise would be subject to creditor's claims.(55)
The Heller court was apparently unconcerned with the effect of its ruling on the trust's creditors since the "trustee expressly represent[ed] that there [were] no current claims and none threatened or reasonably anticipated.(56)
In the above-mentioned statutory schemes, as well as in Heller, an effective balance is struck between the right to create a self-settled spendthrift trust and the rights of existing creditors to reach into those trusts to satisfy their claims if the funding of the trusts constitutes a fraudulent conveyance.(57) As such, the public policy concerns of the courts of other jurisdictions adjudicating the validity thereof should not be implicated, and self-settled trusts should not be regarded any different from spendthrift trusts that are not self-settled. In the form of fraudulent conveyance legislation, every jurisdiction already has a built-in protection against the evil perceived by the Portnoy and Brooks courts that negates the need for a blanket rule vitiating the efficacy of spendthrift trusts validly created under the law of other jurisdictions.(58) Therefore, public policy need not be offended by the legitimate use of self-settled spendthrift trusts in estate and/or asset protection planning, but should only be offended by its abuse as determined by violation of applicable fraudulent conveyance law.(59) In this respect, legislation permitting the creation of a self-settled spendthrift trust is no different from a host of other legitimate planning opportunities, such as the use of ERISA qualified plans, individual retirement accounts, or life insurance or annuity exemptions,(60) to shelter assets from the reach of creditors while at the same time retaining almost complete control over such assets as well as the sole benefit thereof.(61) Moreover, even when such planning opportunities are used for the sole purpose of shielding otherwise non-exempt assets from the claims of existing creditors, the courts have generally recognized such planning as acceptable.(62)
That the law allows a person to limit her exposure to creditors should come as no surprise to anyone, and voluntary creditors, at least, should not be heard to complain since they are presumed to know the extent to which the law will permit them to enforce their claims.
It is believed that every State in the Union has passed statutes by which a part of the property of the debtor is exempt from seizure on execution or other process of the courts; in short, is not by law liable to the payment of his debts . . . This has come to be considered in this country as a wise, as it certainly may be called a settled, policy in all the States. To property so exempted the creditor has no right to lock, and does not look, as a means of payment when his debt is created; and while this court has steadily held, under the constitutional provision against impairing the obligations of contracts by State laws, that such exemption laws, when first enacted, were invalid as to debts then in existence, it has always held, that, as to contracts made thereafter, the exemptions were valid.(63)
Thus, the Supreme Court distinguished between existing and future creditors, based upon "sound and unanswerable reason" since the future creditor
is neither defrauded nor injured by the application of the law to his case, as he knows, when he parts with the consideration of his debt, that the property so exempt can never be made liable to its payment. Nothing is withdrawn from this liability which was ever subject to it, or to which he had a right to look for its discharge in payment(64)
Therefore, if the public policy basis for voiding self-settled spendthrift trusts is based upon an equitable creditors' rights argument, the question must be asked whether the equities are not somewhat distorted by a creditor who chose, in the pursuit of profit, to extend credit based upon exempt assets. Therefore, if it is accurate to state that the real concern is that a debtor will be able to obtain unfair advantage over existing creditors through the use of a self-settled spendthrift trust, the appropriate remedy would be the imposition of sufficient sanctions, whether they be penal or merely pecuniary, to deter those who would otherwise engage in fraudulent conveyances through vehicles that negate the practical risk of transferee liability.
Finally, some consideration must also be afforded to our obvious public policy goal of keeping trust capital (and trust business) within the United States and subject to the jurisdiction of the U.S. judicial system and the Internal Revenue Service. In this respect, although the Portnoy and Brooks courts denied their respective debtors a discharge in bankruptcy, for all intents and purposes, the assets that had been transferred to off-shore fiduciaries will most likely remain unavailable to the debtors' domestic creditors and the Internal Revenue Service. Therefore, a blanket conflict of laws rule that, in the guise of public policy, refuses to validate self-settled spend-thrift trusts under the appropriate circumstances will serve only to ensure the continuing flight of trust capital to foreign jurisdictions where the determination of a domestic court will have no practical effect. In contrast, a rule respecting the vast majority of self-settled spendthrift trusts, which do not defraud the settlor's existing creditors, will put domestic jurisdictions such as Alaska, Colorado, Delaware, Missouri, Nevada and Rhode Island on par with off-shore jurisdictions for legitimate trust business.
If the settlor creates a trust to be administered in a state other than that of his domicil, the law of the state of the place of administration, rather than that of his domicil, ordinarily is applicable. Thus a settlor domiciled in one state may create an inter vivos trust by conveying property to a trust company of another state as trustee and delivering the property to it to be administered in that state. In that case the law of that state will be applicable as to the rights of creditors to reach the beneficiary's interest.
This permits a person who is domiciled in a state in which restraints on alienation are not permitted, to create an inter vivos trust in another state where they are permitted and thereby take advantage of the law of the latter state.(18)
In fact, in some jurisdictions a settlor's ability to designate the law of a particular jurisdiction as the governing law of the trust is expressly provided by statute. For example, Section 7-1.10 of the New York Estates, Powers and Trusts Law provides that "[w]henever a person, not domiciled in this state, creates a trust which provides that it shall be governed by the laws of this state, such provision shall be given effect in determining the validity, effect and interpretation of the disposition in such trust. . . ."(19) Interpreting a prior version of this statute, the New York Court of Appeals in Hutchinson v. Ross stated that "[t]he statute makes [a settlor's] express declaration of intention [of controlling law] conclusive. . . ."(20) A New York Court also noted that "[i]t cannot be doubted . . . that this state encourages the selection by residents of other states of New York as the situs of trusts."(21) Although the prima facie ability of a domiciliary settlor to create a valid trust governed by the laws of a foreign jurisdiction is not expressly conferred by statute, it is either set forth under existing case law or can be logically inferred.(22) A strong argument can also be made that principles of judicial comity require that a settlor's designation of controlling law be respected by the courts.(23)
The apparent conflict over the import of Section 270 of the Restatement (Second) of Conflict of Laws, as set forth in Portnoy and Brooks and the foregoing authorities is a result of the fact that section 270 is specific to the validity of a trust rather than the efficacy of a purported restraint on alienation of beneficial trust interests. With regard to the conflict of laws issue on this latter matter, section 273 of the Restatement (Second) of Conflict of Laws is the applicable authority. Section 273 provides that:
Whether the interest of a beneficiary of [an inter-vivos] trust of movables is assignable by him and can be reached by his creditors is determined . . .
. . . by the local law of the state, if any, in which the settlor has manifested an intention that the trust is to be administered, and otherwise by the local law of the state to which the administration of the trust is most substantially related.(24)
The express public policy caveat of section 270 is neither repeated in section 273 nor in the official comment.(25) The absence of such a caveat raises the question of whether public policy is an appropriate basis for effectively overturning a settlor's designation of controlling law when the issue is the alienation of spendthrift trust interests rather than the general validity of the trust. Although it cannot be denied that public policy concerns underlie the application of all conflict of laws principles, the express public policy provision in section 270 makes its absence from section 273 conspicuous and suggestive of a relatively low importance vis á vis the application of conflict of laws principles to spendthrift trusts.
Indeed, even the Portnoy and Brooks courts acknowledged that a settlor may generally specify the trust's controlling law.(26) For this reason, each court most likely misconstrued the question before it as one of validity under section 270, rather than administration and efficacy of the spendthrift provision under section 273. Moreover, even under section 270, each court simply chose to assume the premise that it wished to prove; that is, the law of the forum should govern because it provides that self-settled trusts are void as to the settlor's creditors.(27) Such reasoning, however, constitutes an obvious nonsequitor. Although application of the foreign law may, arguendo, have violated a strong public policy of the forum, such a finding cannot deliver the courts' desired result unless it is also the case that "as to the matter at issue, the trust has its most significant relationship" to the forum.(28)
On this latter point, although the principles contained in section 6 of the Restatement (Second) of Conflict of Laws, recited above, are quite general, it seems questionable whether, as to the matter at issue, the Portnoy and Brooks trusts would have their most significant relationship with the forum state. This issue would most likely turn on the location of the primary administration of the trust.(29) For example, a trust designates the law of the Jersey Channel Islands as controlling, and the trustee resides in the Jersey Channel Islands with the vast majority of trust transactions taking place in the Jersey Channel Islands, but the trust settlor is a resident somewhere in the United States. It would appear that a domestic creditor, with a cause of action against the trust settlor, would be hard pressed to argue that the United States has a more significant relationship with the trust as to that cause of action than the Jersey Channel Islands. Aside from the cases dealing with self-settled trusts, there seems to be no authority suggesting that a court can refuse to apply the law declared by the trust settlor simply because the debtor/beneficiary resides in the forum state.(30) Although the public policy concerns of the forum state may well differ when the trust is self-settled, focusing on self-settlement begs the applicable question: "as to the matter at issue," which state has the most significant relationship to the trust?
Moreover, in contrast to the implication of Portnoy and Brooks, the fact that the forum state does not permit self-settled spendthrift trusts to be created under its own law does not necessarily mean that it would violate a strong public policy of the forum state to recognize a self-settled spendthrift trust if it was validly created under the law of a foreign jurisdiction. In fact,
"[i]t would seem that the policy of a state, whether it be to restrain alienation in order to protect the beneficiary, or to permit alienation in order to protect creditors and assignees, is not so strong as to preclude the application of the law to the contrary prevailing in another state."(31)
Although not dealing with the efficacy of a restraint on alienation of a self-settled spendthrift trust interest, the Fifth Circuit stated that:
Mere difference between the law of the forum and that of the foreign State does not of itself prevent enforcement of the foreign law or rights based thereon if such law is not against the public policy of the forum. The fact, therefore, that under Florida law the trust agreement is presumptively void does not prevent a Florida court from applying the law of Minnesota, where the agreement was made and under which law the agreement is presumptively valid. Such difference in the law of Florida and that of Minnesota does not of itself prevent enforcement in Florida of the Minnesota contract and the rights based thereon, since the difference is not contrary to the prohibitory law of that forum.(32)
In addition, in every case where the enforcement of the law of another jurisdiction appears contrary to the public policy of the forum state, principles of judicial comity provide a counterbalancing public policy that the validity of the law of such other jurisdiction be enforced.(33)
There are also a number of cases that have applied conflicts of law principles to spendthrift trusts without resort to public policy. For example, though not considered in either the Portnoy or Brooks opinions, the bankruptcy court's decision in Togut v. Hecht seems to provide direct precedent for both cases.(34) At issue in Togut was ". . . whether the laws of the State of Maryland or New York are applicable in determining the validity of the spendthrift trust provisions. . . "(35) In Togut, the debtor argued for the application of Maryland law, because it would preclude the bankruptcy trustee from claiming any portion of the spendthrift trust's undistributed income and principal as a part of the bankruptcy estate.(36) The bankruptcy trustee argued that the law of the forum state of New York should apply, because under the law of New York, the bankruptcy trustee would be entitled to ten percent of the trust's undistributed income as well as any portion of the remaining ninety percent of such income that might be in excess of the debtor's reasonable living requirements.(37) The bankruptcy court's determination that the law of Maryland was the "applicable non-bankruptcy law" for purposes of determining the Bankruptcy Code section 541(c)(2) exemption(38) was based solely upon the trust settlor's designation of Maryland law as the law governing "all questions pertaining to [the trust's] validity, construction and administration."(39) The court apparently did not consider the possibility that the application of the more broadly based Maryland spendthrift laws might offend the public policy concerns of the bankruptcy court's forum of New York. The Bankruptcy Court's decision in Togut is, therefore, difficult to reconcile with Portnoy and Brooks, as all three cases dealt with the application of conflict of laws principles to the spendthrift trust exemption under section 541(c)(2).(40) It is especially difficult to reconcile Portnoy and Togut since both cases were decided in a New York forum that presumably had the same public policy in Portnoy that it did a mere nine years earlier in Togut.
Of the cases outside the bankruptcy area concerning the application of conflict of laws principles to spendthrift trusts, many respect the settlor's express designation of controlling law, notwithstanding that such a result seems to frustrate public policy concerns at least as important as the protection of creditors' rights. Most telling, perhaps, are those cases that deal either with a spousal right of election or the rights of parties in marital contests, as both types of cases implicate a substantial public policy recognized in all states. For example, in The National Shawmut Bank of Boston v. Cumming,(41) the settlor, a domiciliary of Vermont, created a trust of "the greater part of his property," which trust the settlor designated to be "construed and the provisions thereof interpreted under and in accordance with the laws of the Commonwealth of Massachusetts."(42) As recognized by the lower court's opinion, the Shawmut settlor's clearly implied intent in designating Massachusetts law as controlling, was to defeat his surviving spouse's significantly greater inheritance rights under Vermont law.(43) According to the Shawmut court:
[i]f the settlor had been domiciled in this Commonwealth and had transferred here personal property here to a trustee here for administration here, the transfer would have been valid even if his sole purpose had been to deprive his wife of any portion of it. The Vermont law we understand to be otherwise and to invalidate a transfer made there by one domiciled there of personal property there, if made with an actual, as distinguished from an implied, fraudulent intent to disinherit his spouse.(44)
In holding that Massachusetts law should apply, thereby depriving the surviving spouse of the greater part of her inheritance rights, the Shawmut court stated that "[t]he general tendency of authorities elsewhere is away from the adoption of the law of the settlor's domicil where the property, the domicil and place of business of the trustee, and the place of administration intended by the settlor are in another State."(45)
If the courts, nevertheless, insist upon a general public policy review whenever a self-settled spendthrift trust comes within their purview, their natural impulse towards automatic reliance on precedent must be tempered by recognition that our society has changed significantly since the Restatement (Second) of Conflict of Laws took its snap-shot of the law more than 40 years ago. It is a truism that notions of public policy are not static, but vary with time and place, and courts are obliged to revisit public policy if they choose to cite to it as a judicial check against otherwise permissible estate and asset protection planning opportunities. In this regard, it was not until the United States Supreme Court decided Nichols v. Eaton(46) in 1875 that the general validity of spendthrift trusts, which today we take for granted in this country, was first recognized throughout the United States. In Nichols the court broke with a long tradition of English common law on spendthrift trusts, which to this day invalidates spendthrift trust protections in that country:
We concede that there are limitations which public policy or general statutes impose upon all dispositions of property, such as those designed to prevent perpetuities and accumulations of real estate . . . . We also admit that there is a just and sound policy . . . to protect creditors against frauds upon their rights. . . . But the doctrine, that the owner of property . . . cannot so dispose of it, but that the object of his bounty . . . must hold it subject to the debts due his creditors . . . is one which we are not prepared to announce as the doctrine of this court.(47)
Another example of the vagaries of public policy over time is the recent spate of legislative negation of the Rule Against Perpetuities in this country. When Nichols v. Eaton was decided in 1875, the Rule Against Perpetuities was viewed as a necessary limitation on potential restraints on the alienability of property. Today, eleven states have repealed the Rule Against Perpetuities and a number of additional states are considering such changes.(48) Therefore, while on the one hand it may be argued there has been an erosion of the protections offered by spendthrift trusts in this country,(49) on the other hand it can be said that spendthrift trust protections are expanding.(50) In the aggregate these developments simply evidence the public policy pendulum swinging in different directions in response to the social and economic needs of our changing society.
Bankruptcy courts, however, have failed to take judicial notice of the recent trend of domestic jurisdictions to validate self-settled spendthrift trusts, both legislatively and judicially, provided the circumstances surrounding settlement are not deemed inequitable.(51)
In addition, although it cannot be considered part of this recent trend since it was initially enacted in 1861, in line with the foregoing is Colorado Revised Statutes section 38-10-111, which provides that "[a]ll deeds of gift, all conveyances, and all transfers or assignments, verbal or written, of goods, chattels, or things in action, or real property, made in trust for the use of the person making the same shall be void as against the creditors existing of such person"(52) Caselaw has settled the Colorado statute's obvious logical interpretation that as to future creditors, a self-settled Colorado spendthrift trust will be effective to protect the settlor's retained beneficial interest.(53)
Even New York, where the Portnoy court found the notion of a self-settled spendthrift trust to be offensive, has taken a step towards the recognition of such trusts under the appropriate circumstances. In Matter of Heller, an apparent case of first impression, the New York Surrogate's Court permitted the severance of "an irrevocable inter-vivos trust into two trusts for the novel purpose of insulating the trust's substantial cash and securities from potential creditor's claims that could arise from the trust's real property."(54) The severance of the trust into two portions, in effect, caused the creation of a self-settled spendthrift trust vis á vis the existing trust. In allowing this self-settled spendthrift trust to be created, the Heller court rightfully acknowledged that
New York law recognizes the right of individuals to arrange their affairs so as to limit their liability to creditors, including the holding of assets in corporate form, making irrevocable transfers of their assets, outright or in trust, as long as such transfers are not in fraud of existing creditors, establishing spendthrift trusts to protect the assets from the beneficiary's creditors and renouncing property interests that otherwise would be subject to creditor's claims.(55)
The Heller court was apparently unconcerned with the effect of its ruling on the trust's creditors since the "trustee expressly represent[ed] that there [were] no current claims and none threatened or reasonably anticipated.(56)
In the above-mentioned statutory schemes, as well as in Heller, an effective balance is struck between the right to create a self-settled spendthrift trust and the rights of existing creditors to reach into those trusts to satisfy their claims if the funding of the trusts constitutes a fraudulent conveyance.(57) As such, the public policy concerns of the courts of other jurisdictions adjudicating the validity thereof should not be implicated, and self-settled trusts should not be regarded any different from spendthrift trusts that are not self-settled. In the form of fraudulent conveyance legislation, every jurisdiction already has a built-in protection against the evil perceived by the Portnoy and Brooks courts that negates the need for a blanket rule vitiating the efficacy of spendthrift trusts validly created under the law of other jurisdictions.(58) Therefore, public policy need not be offended by the legitimate use of self-settled spendthrift trusts in estate and/or asset protection planning, but should only be offended by its abuse as determined by violation of applicable fraudulent conveyance law.(59) In this respect, legislation permitting the creation of a self-settled spendthrift trust is no different from a host of other legitimate planning opportunities, such as the use of ERISA qualified plans, individual retirement accounts, or life insurance or annuity exemptions,(60) to shelter assets from the reach of creditors while at the same time retaining almost complete control over such assets as well as the sole benefit thereof.(61) Moreover, even when such planning opportunities are used for the sole purpose of shielding otherwise non-exempt assets from the claims of existing creditors, the courts have generally recognized such planning as acceptable.(62)
That the law allows a person to limit her exposure to creditors should come as no surprise to anyone, and voluntary creditors, at least, should not be heard to complain since they are presumed to know the extent to which the law will permit them to enforce their claims.
It is believed that every State in the Union has passed statutes by which a part of the property of the debtor is exempt from seizure on execution or other process of the courts; in short, is not by law liable to the payment of his debts . . . This has come to be considered in this country as a wise, as it certainly may be called a settled, policy in all the States. To property so exempted the creditor has no right to lock, and does not look, as a means of payment when his debt is created; and while this court has steadily held, under the constitutional provision against impairing the obligations of contracts by State laws, that such exemption laws, when first enacted, were invalid as to debts then in existence, it has always held, that, as to contracts made thereafter, the exemptions were valid.(63)
Thus, the Supreme Court distinguished between existing and future creditors, based upon "sound and unanswerable reason" since the future creditor
is neither defrauded nor injured by the application of the law to his case, as he knows, when he parts with the consideration of his debt, that the property so exempt can never be made liable to its payment. Nothing is withdrawn from this liability which was ever subject to it, or to which he had a right to look for its discharge in payment(64)
Therefore, if the public policy basis for voiding self-settled spendthrift trusts is based upon an equitable creditors' rights argument, the question must be asked whether the equities are not somewhat distorted by a creditor who chose, in the pursuit of profit, to extend credit based upon exempt assets. Therefore, if it is accurate to state that the real concern is that a debtor will be able to obtain unfair advantage over existing creditors through the use of a self-settled spendthrift trust, the appropriate remedy would be the imposition of sufficient sanctions, whether they be penal or merely pecuniary, to deter those who would otherwise engage in fraudulent conveyances through vehicles that negate the practical risk of transferee liability.
Finally, some consideration must also be afforded to our obvious public policy goal of keeping trust capital (and trust business) within the United States and subject to the jurisdiction of the U.S. judicial system and the Internal Revenue Service. In this respect, although the Portnoy and Brooks courts denied their respective debtors a discharge in bankruptcy, for all intents and purposes, the assets that had been transferred to off-shore fiduciaries will most likely remain unavailable to the debtors' domestic creditors and the Internal Revenue Service. Therefore, a blanket conflict of laws rule that, in the guise of public policy, refuses to validate self-settled spend-thrift trusts under the appropriate circumstances will serve only to ensure the continuing flight of trust capital to foreign jurisdictions where the determination of a domestic court will have no practical effect. In contrast, a rule respecting the vast majority of self-settled spendthrift trusts, which do not defraud the settlor's existing creditors, will put domestic jurisdictions such as Alaska, Colorado, Delaware, Missouri, Nevada and Rhode Island on par with off-shore jurisdictions for legitimate trust business.
Conclusion
It is unfortunate, but perhaps not terribly surprising, that the first two reported cases to consider the application of conflict of laws principles to self-settled spendthrift trusts both involved "bad facts" from an asset protection planning standpoint. In this regard, the adage "bad facts produce bad law" is not a slight on the courts, but rather an acknowledgment of a court's primary duty to do substantial justice to the parties immediately before it. However, in an effort to do substantial justice to the parties immediately before them, the Portnoy and Brooks courts have forged what may well become the first two links in an overly stiff and unyielding chain of precedent upon which future courts will rely without due analysis of the conflict of law issue. We do not suggest that debtors are bereft of any moral obligation to creditors, nor that the courts should countenance fraudulent conveyances simply because they may be valid under the law of another jurisdiction. We suggest instead that there must be a balancing of interests recognizing that our society continues to evolve, and that our common law must do so as well. In summary, a self-settled spendthrift trust, if valid under the law of a sister state, or even the law of a foreign state, should be respected if it were created for legitimate estate or asset protection planning purposes but should provide no spendthrift protection if not.
This article is reproduced with the consent of the copyright holder, West Group.
This article is reproduced with the consent of the copyright holder, West Group.
