October 1998 Hot Topics

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Copyright 1998 Robert L. Sommers, all rights reserved.

Off-Shore Asset Protection Trusts - Part 2

Fraudulent Transfers

The first major hurdle that an asset protection plan must clear is the concept that an actual or potential debtor cannot remove assets from his ownership to prevent a potential or actual creditor from collecting on a judgment.  Unfortunately, most people interested in asset protection have a pending claim against them.  A transfer of property to an off-shore asset protection trust may constitute a fraudulent transfer under the Uniform Fraudulent Transfer Act. (California’s version of the Act is found in California Civil Code Sections 3439 et. seq.]  If the settlor has already committed an act that could give rise to a legal claim against him, it is usually too late to transfer assets to a foreign trust.

There are two basic types of fraudulent transfers that creditors may challenge: actual intent and constructive intent transfers.

1. Actual Intent Transfers: A transfer is deemed fraudulent and may be set aside if it is made with the "actual intent to hinder, delay or defraud any creditor" of the transferor, whether present or future. California Civil Code Sec. 3439.04(a).

2. Constructive Intent Transfers:  Generally, a constructive fraudulent transfer occurs when property is transferred for "less than reasonable value," if any of the following three requirements are met:

a. The debtor is left with "unreasonably small" assets for carrying out the business in which the debtor is engaged or about to engage. (California Civil Code Sec. 3439(b)(1));

b. The debtor intended to incur, or reasonably believed or reasonably should have believed, that he or she would incur debts beyond his or her ability to pay as they became due. (California Civil Code Sec. 3439.04(b)(2)); or

c. The debtor was insolvent or became insolvent as a result of the transfer. (Civil Code Sec. 3439.05).

Generally, there is a four-year statute of limitations for "constructive" fraudulent transfers.  For "actual intent" fraudulent transfers, legal action can be brought at any time before the later of (1) four years after the transfer was made; or (2) within seven years of when the transfer was made, as long as the action is brought within one year after the transfer or obligations could reasonably have been discovered by the claimant. (Civil Code Sec. 3439.09).

The fraudulent conveyance laws prevent those with actual creditors from using asset protection. The ideal client is one with no actual creditors and who is lucky enough not to have a creditor appear on the scene within four years after the transfer has been made.  Unfortunately, this is but one of several roadblocks confronting the asset protection scheme.


Potential Criminal Liability Involving Asset Protection Schemes

In addition, every person (which may include the perpetrator’s advisors) who is part of a fraudulent conveyance with the intent to defraud or deceive others, may be guilty of a crime (California Penal Code Section 531).

Under federal law, 18 USC 371, an attorney may be convicted of engaging in a criminal conspiracy to defraud the United States.  A conspiracy exists when two or more people agree to commit a crime against the United States and there, in furtherance of their agreement, one of the conspirators commits an overt act.  Clearly, the participation of an advisor in the formation of an asset protection trust to evade U.S. taxes would fall within the criminal conspiracy statutes.

Engaging in fraudulent asset protection schemes may also violate the Racketeer Influenced and Corrupt Organizations law ("RICO"). 18 USC 1961 et seq.   If two acts of racketeering occur within a 10-year period, and the perpetrator was associated with the enterprise and participated in the conduct of its affairs through the operation or management of its operations, he could be convicted under the RICO laws.   An enterprise can mean an informal activity, such as an asset protection trust. Also, a crime such as mail fraud can be an offense that triggers the application of the RICO laws.

Also, the Money Laundering Control Act, 18 U.S.C. 1956, ("Act") is broad enough to encompass asset protection schemes.  Many people mistakenly believe the federal money laundering statutes apply only to drug trafficking or organized crime.  Actually, the list of potential offenses is quite long and includes tax evasion (IRC Sec. 7201),tax fraud and false statements relating to taxes (IRC. Sec. 7206).

Committing a crime of tax evasion, then concealing the proceeds with foreign bank accounts, violates the Act.  The Act states that if the government can show: (1) that the defendant knew that the property involved in a transaction represented the proceeds from a criminal activity; and (2) that the defendant intended to engage in tax evasion or filing a false tax return, or knew the transaction was designed to conceal the proceeds of a crime or to avoid the reporting requirement under federal or state law, then the defendant can be subject to a $500,000 fine and sentenced up to 10 years in prison.

In the context of asset protection, if the crime of tax evasion or filing a false tax return has been committed, then the act of concealing the proceeds through foreign banks, the failure to disclose the transaction as required under the new trust reporting requirements (discussed below), or the failure to disclosed related party transactions with IRS Form 5472,  could constitute a violation of the money laundering statute.

The taxpayer's advisors are subject to IRC Sec. 7206 which states that any person who willfully aids or assists in the preparation of a false return is also liable.  Consequently, an advisor who counsels a client to violate U.S. tax law (including advising a client that certain reporting requirements can be ignored), and then assists the client in an off-shore asset protection scheme, can be prosecuted under the Act. 


These Trusts Are Under Attack on Many Fronts

A recent article in Forbes magazine illustrates the ingenuity of judges in dealing with off-shore asset protection trusts.  For instance, a bankruptcy judge recently ruled that the court had the power to cancel a debtor's stock ownership in several corporations (the stocks were placed in an off-shore trust to shield them from U.S. creditors).  The court then ordered new stock issued to the creditors.  The result: The asset protection trust contained worthless stock and, therefore, failed to protect the debtor from this creditors.

Although some of the foreign laws, such as the highly-touted Cook Islands anti-creditor legislation, were drafted by  U.S. attorneys, a recent creditor challenge to these rules was successful.  As it turns out, the Cook Islands use New Zealand judges to rule on legal issues.  Evidently, the judge (a foreigner) had little problem interpreting the asset protection laws in favor of the creditor.  The lesson: Some of these jurisdictions are so small, they do not have native judges to enforce their laws.  Foreign judges have little incentive to uphold laws that are blatantly anti-creditor.

In another bizarre case, a U.S. debtor using an Island of Jersey asset protection trust was tossed into a Jersey criminal hospital by a pursuing creditor.  The creditor used an obscure law that allowed the jailing of debtors who might flee the country!  The lesson: If you thought debtor's prison was a concept long since outlawed by countries following English common-law, think again.   As the settlor of a Jersey trust discovered, the concept of debtor's prison was apparently alive and well in the Island of Jersey.

Not only are U.S. judges and creditors becoming more aggressive in pursuing assets secreted in asset-protection countries, attorneys in those countries are bursting through the asset-protection laws to recover assets on behalf of creditors. The Forbes article states that one of the attorneys who helped draft the Cook Islands' legislation has switched sides and now represents creditors pursuing the assets contained in these trusts!

The lesson:  If your asset-protection trust is challenged, expect an expensive legal battle in the foreign jurisdiction.  And if you attend the proceedings, watch out for debtor's prison.  Of course, if you don't attend the lawsuit or fail to provide evidence to defend your position, expect the judge to rule against you.


Settlor "Spendthrift Trusts

U.S. courts have held, as a matter of public policy, a settlor cannot place assets in trust for his benefit and simultanteous protect those assets against the claims of his creditors.  While many trusts contain "spendthrift" clauses which prevent a creditor from reaching the interest of a beneficiary (a spendthrift provison states that a beneficiary cannot transfer or assign a trust interest to a creditor), spendthrift clauses are void as against public policy when the settlor is the beneficiary seeking spendthrift protection.  The Restatement (Second) of Trusts, Paragraph 152 (2) states the rule followed in the U.S. as follows:

Where a person creates for his own benefit a trust for support or a discretionary trust, his transferee or creditors can reach the maximum amount which trustee under the terms of the trust could pay to him or apply for his benefit.

Thus, a transfer to an irrevocable trust by the settlor for the settlor's own benefit will not prevent creditors from reaching the assets, even when the settlor is merely a discretionary beneficiary (the trustee has complete discretion whether or not to make distributions).  Also, settlors should expect a public policy attack against trusts in which they have no beneficial interest, but retain the power to revoke the trust, although there are not yet case law deciding this point.

Most foreign asset-protection jurisdictions have enacted trust legislation repudiating  Paragrpah 152(2) of the Restatement (Second) of Trusts. Therefore, these jurisdictions have enacted laws contrary to settled U.S. trust principles and at least one U.S. court (discussed below) has refused to apply the trust law of a foreign jurisdiction in which the trust was settled because the foeign law violated U.S. public policy.


Will Foreign Asset Protection Trusts Protect Your Assets?

Although asset protection is a hot topic in the law and has its zealous adherents, thus far, the foreign asset protection trust has failed to protect U.S. debtors against their creditors.  There are no U.S. cases specifically upholding the technique and a recent bankruptcy court case could spell the death knell for this mini-industry.

In Re B.V. Brooks, 217 B.R. 98 (United States Bankruptcy Court, D. Connecticut, January 26, 1998), the debtor in a Chapter 11 bankruptcy reorganization transferred stock certificates, representing the debtor's interests in Connecticut corporations, to his wife.  His wife then transferred the stocks to two off-shore irrevocable trusts located in Jersey and Bermuda.  Each trust named the debtor as beneficiary, stated that local law (the laws of Jersey and Bermuda) would apply, and contained "spend-thrift" clauses preventing the beneficiary from assigning or transferring his beneficial interest.  The trustee was given broad discretion to distribute principal.  Income distributions were evidently mandatory.  In short, this was the typical situation in which an off-shore asset protection trust was supposed to prevent the creditors from pursuing the debtor's assets. By creating this trust, the debtor could be secure in the knowledge that he was safe from U.S. lawsuits and creditors.

Note:  The debtor did not voluntarily file a bankruptcy petition.  An involuntary Chapter 7 petition was filed against him and the Chapter 7 proceeding was later converted to a Chapter 11.  Therefore, the jurisdiction of the U.S. Bankruptcy Court was forced upon him by his creditors.

Unfortunately for the debtor, the Bankruptcy Court had little trouble declaring that Connecticut law applied and that the debtor, under Connecticut law (and most other state trust law), could not create a spend-thrift trust to protect himself against his creditors.  The court found that a trust which names the settlor as the beneficiary is invalid to the extent of the settlor's interest.  The court found the wife acted as the agent of the debtor, and, thus, he was the real settlor of the foreign trust.  The court then ruled that the stocks were property of the bankruptcy estate.

The importance of this finding cannot be over-emphasized.  It stands for the proposition that a U.S. person cannot, directly or indirectly, create a trust and place his assets beyond the reach of his creditors.  Also, the asset-protection industry's focus on which foreign jurisdiction contains the best anti-creditor laws has been misplaced.  The U.S. courts have little interest in applying the laws of a foreign jurisdiction when to do so would contravene the public policy of the domestic jurisdiction.  As the judge in the Brooks case stated:

...Connecticut will not '...enforce the law of another jurisdiction nor the rights arising thereunder, which ...contravene [Connecticut] public policy.'

Also, the Brooks court held that the legality of a trust of personalty [non real estate assets] is determined by the law of the settlor's domicile.   This finding also damages, if not destroys, the "foreign-jurisdiction-as-controlling" argument espoused by the asset protection adherents.  Many off-shore protection adherents create a domestic limited liability company or corporation to hold U.S. real property or business interests, then place the membership or stock interests in an off-shore trust.  These ownership interests, however, are personalty and, according to the Brooks decision,  fall within the jurisdiction of the settlor's domicile.  Therefore, unless there is an actual transfer of cash or securities to the off-shore jurisdiction, a U.S. court can reach the assets located in the U.S., thereby destroying the central tenant of asset-protection theory.

The lesson:  The underlying foundation of foreign jurisdiction asset protection has been severely shaken by the Brooks decision.  If a foreign trust's creditor protection laws are to be ignored by domestic courts, then a creditor may haul the debtor into U.S. court and have the trust declared invalid to the extent of the debtor's beneficial interest in the trust.

Note: Since there are huge gift tax concerns when a debtor creates an irrevocable trust and divests himself of any ownership or beneficial interest in the trust, the debtor will usually retain a beneficial interest or otherwise make the trust a grantor trust for U.S. tax purposes (which, in turn, permits a U.S. court to invalidate the spend-thrift provisions of the foreign trust).


Conclusion

When the risks are considered, it appears that at this stage, an off-shore asset-protection trust is merely an expensive gimmick.  It offers little actual protection and is expensive to set up and maintain.  There are no reported U.S. cases in which judges have upheld the validity of off-shore trusts as an effective method to shield a debtor's assets from his creditors.   Moreover, U.S. courts have had little difficulty applying traditional trust law to invalidate the supposed protection against creditors offered by foreign jurisdictions.

The trust promoters claim that U.S. judgments will not be enforced by the foreign jurisdictions, but this unproven supposition rests on the shaky notion that the judges hearing these cases in the foreign jurisdictions will honor these rouge concepts, drafted in contravention of settled U.S. trust principles,  in favor of debtors.  So far, there is little evidence of this.  Also, there are enterprising attorneys in the asset-protection jurisdictions actively assisting creditors.  Finally, there may be obscure laws, akin to debtor's prison, that might force an unsuspecting U.S. debtor into the slammer.

In conclusion, there are grave risks and little rewards associated with off-shore asset protection trusts.  Until there is a U.S. court decision recognizing the validity of these instruments, potential customers should view these arrangements with a healthy dose of skepticism.


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