Has Offshore Trust Litigation Spoiled the Fun? Recent Decisions Regarding Offshore Trusts

The effectiveness of the so-called 'spendthrift trust' in protecting an individual's beneficial trust interest from his creditors has been firmly estab-lished in the United States ever since the Supreme Courts 1875 landmark decision in Nichols v. Eaton. The Nichols case, howev-er, involved a spendthrift trust created for the benefit of a third party beneficiary rather than for the settlor herself.

With limited exceptions, the laws of the U.S. do not permit an individual to place assets in trust for her own benefit (a 'self-settled trust"), and effectively place those assets beyond the reach of creditors. This is true whether the settlor's creditors are pre-sent or future, reasonably anticipated or impossible to foresee. For this reason, U.S. residents must look to the laws of select off-shore jurisdictions which, seeking to gener-ate trust business and attract U.S. capital, have statutorily extended common law spendthrift protections to self-settled trusts provided that the trust was not created or funded in fraud of existing creditors.

Self-settled spendthrift trusts

In the abstract, at least, a self-settled spend-thrift trust, if valid under the law designat-ed by the settlor as governing the trust, should also be held valid by a United States court. The domestic law of trusts provides that a settlor may designate the law of any jurisdiction as governing the settlement notwithstanding conflict between the desig-nated law and the law of the settlor's residence. Practically speaking, however, a self-settled spendthrift trust will still have to pass what may euphemistically be called the "smell test" if the settlor may ultimately have to obtain judicial sanction of the pro-tections afforded by the trust.

Obviously, the smell test is an amorphous one and may mean different things to dif-ferent courts depending on the varying predilections of the individual judge that is presiding. Moreover, pursuant to the axiom that "the squeaky wheel gets the grease", the majority of those few courts that have ruled so far on creditor challenges to off-shore, self-settled spendthrift trusts have been forced to adjudicate cases involving egregious facts. Of course, this undermines the value of their rulings as precedent for future settlors who engage in permissibly prudent asset protection planning using a similar vehicle. Nevertheless, if only by negative implication, a review of those cases may help to delineate the circumstances in which an offshore, self-settled spendthrift trust will be upheld by a U.S. court, and the circumstances in which it will not.

Fraudulent transfers

In the first instance, it should surprise no one that courts will not sanction a trust if funded in a manner which has been, or like-ly will be, found to be one or more of a series of fraudulent transfers. In this regard, a triad of recent United States Bankruptcy Court cases serves to empha-size the point.

In the 1996 United States Bankruptcy Court case of In re Portnoy, the court sum-marized the pertinent facts by stating that at the heart of the case lay an irrevocable off-shore trust into which the debtor placed virtually all of his assets at a time when he knew that his personal guarantee of his corporation's indebtedness was about to be called." Against this backdrop, the court considered whether it should rule on the Bankruptcy Code's spendthrift trust exemp-tion by applying New York law (which does not allow self-settled spendthrift trusts), or by applying the law of Jersey, Channel Islands. The court, in a result-oriented analysis of conflict of law issues, found New York law applicable and on public pol-icy grounds held the trust's assets includable in the debtor's bankruptcy estate.

In the 1998 Bankruptcy Court case of In re B. V Brooks, the issue before the court was again whether to apply domestic (in this case, Connecticut) law, or foreign law to the spendthrift trust exemption under the Bankruptcy Code. Citing Portnoy as prece-dent, and following another seemingly result-oriented analysis of conflict of law rules, the court found the assets of the debtor's two trusts includable in the bank-ruptcy estate notwithstanding the fact that they were valid spendthrift trusts under the laws of Bermuda and Jersey, Channel Islands.

Although very little of the case's factual background was actually reported, the Bankruptcy Court did note that the debtor/settlor was the primary beneficiary of each of the trusts and had the right to receive all of the income. In addition, the unreported facts apparently caused the court to perceive the funding of the trusts as fraudulent since the Court twice character-ized the debtor's acts in creating the trusts as a 'scheme". This perception was likely buttressed by the timing of the case, since the trusts were funded in 1990 and an involuntary bankruptcy petition was filed against the debtor the following year.

In a later 1998 Bankruptcy Court case, In re Stephan Jay Lawrence, following a forty-two month arbitration and just sixty-six days before an award in excess of US$20 million was entered against him, the debtor funded an offshore trust citing first the law of Jersey, Channel Islands, and about a month later, the law of Mauritius, as gov-erning. Citing both Portnoy and B. V Brooks, the Bankruptcy Court found that the sole purpose of the trust was to shield the debtor's assets from a creditor which "was about to obtain a staggering $20 million arbitration award against him" and that "the timing of the trust's creation is further evidence of this intent." The court also found the debtor's testimony before the court not to have been credible (and on sev-eral occasions perjurious), and that the debtor was shockingly less than candid" with the court. The court, therefore, entered judgment against the debtor, thereby denying him a discharge in bankruptcy.

Other cases with egregious fact patterns will likely garner similar results, although sometimes based on different legal theories. For example, the courts will not uphold a trust funded with illegally obtained assets. In Grupo Torras, Grupo Torras, S.A. v. S. EM. Al Sabah, Chemical Bank & Trust (Bahamas) and Private Trust Corp., the plaintiffs challenged a Bahamian trust on various grounds, including the fact that it was funded with assets obtained by the settlor through defrauding the plaintiffs. Citing long-standing principles of English common law, the Bahamian Supreme Court held that the spendthrift trust protections afforded by Bahamian law do not apply to illegally obtained assets.

Legitimate purposes

In stark contrast to the foregoing cases, the factual background of Riechers v. Riechers, a New York matrimonial action, allowed the court to perceive the trust in a much more favorable light. In 1992, following several medical malpractice suits against him, the settlor established a self-settled spendthrift trust under the law of the Cook Islands to guard against the likelihood of future med-ical malpractice claims. At the same time, the settlor and his wife were having marital difficulties, but the wife was aware that the trust was bein8 established. In 1994, the wife commenced an action for divorce and sought to have the trust included in com-puting an equitable distribution award. The court noted that since it was established 'for the legitimate purpose of protecting family assets", the court did not have juris-diction over the trust and that issues such as whether the wife would be entitled to any trust property should be left to a Cook Islands court to decide.

The Riechers decision, perhaps more than anything else, proves the adage that "bad facts make bad law" and strongly suggests that U.S. courts are inclined to uphold the protections afforded by an offshore, self-settled spendthrift trust, provided that the trust was created and funded under appro-priate circumstances.

First, the trust should be as separate as pos-sible from its settlor. This requires an inde-pendent, if friendly, trustee, who has con-trol of the trust's assets exclusive of the settlor. By wrapping the assets within a limit-ed partnership of which the settlor is a one percent general partner and the trust is a ninety-nine percent limited partner, the settlor can actually retain effective control of the assets without affecting the independent control of the trust. Additionally, it would be advisable to give the trustee discretion to distribute trust assets to persons in addition to the settlor (called a "sprinkling power"), such as the settlor's spouse and descen-dants. Second, the circumstances surround-ing the creation or funding of the trust must be as distant as possible from a potential creditor's claim. What this means is that the trust should be set up as early as possi-ble for the purpose of guarding against future, rather than current, creditors.

Practical impediments

At the end of the day, however, the offshore trust's effectiveness as a tool to thwart future creditors will most likely not depend on whether a U.S. court gives credence to the application of foreign trust law when adjudicating a claim against the settlor. Provided that the trust's assets are located offshore (whether that be in the jurisdiction of the trust's governing law or an estab-lished financial center such as Switzerland or Luxembourg), a creditor with a U.S. judgment will still be faced with significant hurdles before actually being able to levy on any of the trust's assets.

The best evidence of the practical impedi-ments to enforcing a U.S. judgment against an offshore trust is the fact that since the Cook Islands enacted the world's first asset protection trust legislation in 1989, and notwithstanding the creation of thousands of such trusts since that time, there has only been one reported case in that jurisdiction, 515 S. Orange Grove Owners Association v. Orange Grove Partners, which deals with an asset protection trust. Furthermore, although Orange Grove is sometimes sug-gested to be a creditor victory because the trust was restrained and the creditor's claims were allowed to proceed, no Cook Islands judgment was ever entered other than on the aforementioned procedural issues. This supports the purported result that the creditor ultimately settled its claim for a fraction of the trust's assets. Moreover, since the court's holding was wholly based upon an ambiguity in the gov-erning statute -- an ambiguity that was sub-sequently clarified by statutory amendment -- future creditors who make it as far as the Cook Islands will not be able to follow in the footsteps of the Orange Grove creditors.

Conclusion

Although in the end other factors may induce a settlement of the creditor's claims, it cannot be said that these trusts are inef-fective simply because the judgment of a U.S. court remains uncertain. In fact, if a settlor can negotiate a settlement with his creditors on significantly more favorable terms than would have been possible with-out the trust, the effectiveness of offshore trusts for asset protection purposes seems hard to refute.

Gideon Rothschild, JD., CPA., is a partner with Moses & Singer LLP in New York City. Mr. Rothschild chairs the Asset Protection Planning Committee of the Real Properly, Probate and Trust Section of the American Bar Association and concentrates his practice Estate Planning and Asset Protection. Daniel S. Rubin, JD., LL.M., is an associate with Moses & Singer LLP and practices in the Trusts and Estates department. The writers may he reached by email at grothschild@mosessinger.com © 1999 Gideon Rothschild All rights reserved.