Over the past ten years, Domestic Asset Protection Trusts ("DAPTs") have become more and more prevalent. In this post, I will be discussing what a DAPT is, the current state of the law on DAPTs, and why I believe DAPTs are appropriate only in limited circumstances.
[Note: A Domestic Asset Protection Trust ("DAPT") is a very specific type of trust, and does not refer to all trusts used for "asset protection". Many non-DAPT trusts used for "asset protection" may be appropriate in broader circumstances than DAPTs. More on this later.]
[Note: A Domestic Asset Protection Trust ("DAPT") is a very specific type of trust, and does not refer to all trusts used for "asset protection". Many non-DAPT trusts used for "asset protection" may be appropriate in broader circumstances than DAPTs. More on this later.]
To understand DAPTs, I have to start by explaining the traditional law of self-settled trusts. A self-settled trust is a trust where the settlor is also a beneficiary. For those uninitiated, a "settlor" (also called a "grantor") is simply a person who contributes property to a trust. That contributed property is held by the trust for a group of people designated in the trust documents as the "beneficiaries". Under common law principles dating all the way back to olden times in England, if the settlor is also a beneficiary, if the settlor loses a lawsuit, the creditor can seize the assets in the trust.
Let's put this in simple terms. Joe Smith puts $1,000,000 into a trust, naming an independent third party trustee to manage the trust. Under the terms of the trust, the trustee, in his sole and absolute discretion and with no input from Joe Smith, is permitted to distribute any amounts in the trust to Joe Smith. The trustee is also permitted to refuse to make distributions to Joe Smith. Now assume Joe Smith gets sued, loses, and a judgment is entered against him. Under the traditional law of self-settled trusts, the creditor can have access to all trust assets in order to satisfy the judgment. It doesn't matter that the assets are in the control of a trustee.
Now consider a non-self-settled trust. Assume all of the earlier facts except that the trust documents now state that the trustee may only make distributions to Kim Smith, and that Kim Smith is the one who loses the lawsuit instead of Joe. In this scenario, absent fraudulent transfer, Kim's creditor would be unable to attach trust assets, despite the fact that they're set aside for Kim. This is because the trust is not self-settled. The "settlor" is Joe, since he put his assets into the trust, but Joe isn't a beneficiary.
In an effort to attract investors, many small offshore nations started passing laws overriding thousands of years of trust law. These laws in a nutshell stated that in the first example above, the creditor could not reach any assets despite the settlor also being a beneficiary.
In the United States, several states began to fear losing investments to offshore jurisdictions. They therefore passed DAPT statutes, which mirrored the offshore statutes mentioned earlier. The main states in the DAPT game are Delaware, Alaska, and Nevada. There are over a dozen other states with DAPT statutes as well, but their statutes are generally used only by their own in-state residents. On the other hand, Delaware, Alaska, and Nevada actively attract business from residents of non-DAPT states.
The big, unanswered question with DAPTs is this: if I live in a non-DAPT state and I form a DAPT in a DAPT state, will the trust assets be protected if I am sued in a non-DAPT state? In other words, as a New Jersey resident, if I form a Delaware (or Nevada, or Alaska, etc.) DAPT and am later sued in New Jersey court, will my Delaware DAPT hold up? As of the date of my writing this, there is no definitive legal answer to this question. No court of which I am aware has definitively ruled which state's laws would apply to the collections action.
Many promoters of DAPTs claim that the DAPT state's law will apply, and that the trust will hold, by relying on Hanson v. Denckla, 357 U.S. 235 (1958). I believe this case is often relied upon in situations where it doesn't apply. Hanson had a very limited holding. In a nutshell, the court held that a state court cannot apply its laws to a trust formed in another state if: 1. the state court has no in rem jurisdiction, and 2. the state court has no in personam jurisdiction over the trustee. I will address each of those prongs in turn.
For a state court not to have in rem jurisdiction over a trust formed in another state, generally the trust must have no assets located within that state. This prong is actually pretty easy to satisfy. In my example above with a New Jersey resident forming a Delaware DAPT, the New Jersey resident could simply move all of his bank and investment accounts to Delaware, and keep all New Jersey real estate out of the DAPT. The tough part is dealing with in personam jurisdiction over the trustee.
For a state court to not have in personam jurisdiction over a trustee, the trustee must have no "minimum contacts" with that state. What exactly constitutes "minimum contacts" is extremely complex, and is a topic that could occupy an entire law school semester. However, one thing we do know is that if a company solicits business in a certain state, that company has minimum contacts there. See, e.g., McGee v. Int'l Life Ins. Co., 355 U.S. 220 (1957).
And therein lies the problem. It will be very, very difficult to find a trustee for a DAPT that doesn't have minimum contacts in non-DAPT states. Most DAPT trustees are bank and trust companies that solicit business in all 50 states. In the aforementioned NJ-DE example, it would likely be easy for a New Jersey court to assert jurisdiction over a Delaware trust company acting as a DAPT trustee. This is because the trustee likely solicits business in New Jersey. Once the New Jersey court had jurisdiction, it would likely apply New Jersey (not Delaware) law to the collections action, as in conflicts of law issues courts generally apply local law in collections. The court theoretically could then order the trustee to distribute assets to a creditor.
In addition to all of this, in bankruptcy cases DAPTs are subject to an extended 10 year statute of limitations for fraudulent transfers under 11 U.S.C. 548(e). For more on that, read this post.
Delaware does attempt a solution to the jurisdiction issue. Under the Delaware DAPT statute, a trustee is automatically removed upon a finding that an out-of-state court has jurisdiction over the trustee, and a new trustee is appointed by the Delaware Court of Chancery. It's hard to say how this provision would play out when it is tested for the first time. It could lead to a battle between dueling state courts.
DAPTs have their place, but clients should be aware of the risks. There are other strategies I can recommend that don't rely on the law of an outside state, and are therefore in my opinion more likely to be effective. An example of such a strategy is a more traditional trust known as a SLAT, you will be hearing about more on this blog. If you can't wait until later to hear about it, feel free to contact me for more information.
UPDATE 6/27/12: To see how to reduce some DAPT risks, click here.
UPDATE 6/27/12: To see how to reduce some DAPT risks, click here.
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