Tuesday, January 6, 2009

Is a Self-Settled Trust with a Spendthrift Clause Property of the Chapter 7 Estate? The Ninth Circuit BAP Balances the Countervailing Principles

By Andrew Toth-Fejel, Bankruptcy Litigation Support for Attorneys,

Cutter v. Seror (In re Cutter)
Ninth Circuit BAP Nos. CC-07-1436-MoDK, CC-08-1024-MoDK, CC-08-1025-MoDK
Filed September 4, 2008
Amended December 3, 2008

This opinion involves "a failed asset protection scheme" which the BAP published "to call attention to a fundamental fallacy inherent in that scheme," "a self-settled trust that identifies only unnamed “surviving” descendants of the trustor as beneficiaries (whose interests vest only after the trustor’s death), but leaves in the trustor/trustee the power to deplete the trust of all of its assets for his own benefit." As is no doubt clear from this statement of the case by the Court, it ruled in favor of the trustee and against the debtor that certain trust assets could be reached by debtor's creditors and thus were property of his bankruptcy estate. The details of this opinion are valuable guidance for any attorney who creates or tries to preserve asset protection mechanisms, or works to defeat them.

(This opinion, although originally "filed" by the Bankruptcy Appellate Panel in September and amended in early December, only became available on the BAP website for the first time, in its amended form a week or so ago, after a timely petition for rehearing resulted in an amended opinion "correct a factual error and to adjust the legal analysis accordingly." Judge Randall Dunn participated in this Panel but did not author the opinion.)

Critical Facts about the Trust
Although the Court took many pages to lay out the detailed facts regarding the various parcel of real estate at issue and the transactions involving them, and the terms of the trust established by the debtor, the critical facts are as follows: Debtor Cutter created an irrevocable trust in 1989 with himself as trustee and the "primary beneficiaries" his "surviving issue . . . and the lineal descendants of non-surviving issue." Debtor was not named a beneficiary but as trustee the Trust Agreement provided him "sole discretion" to make distributions from the trust "to provide for the health, the education, or the support or maintenance in the customary manner of living of the trustor" while he was alive. The Trust Agreement contained a standard spendthrift clause.

The Property at Issue
The Debtor contributed four items of real property to the trust (the "Trust Properties") between 1992 and 2002 through various means including by quitclaim deed directly by him and by grant deed to the trust by a brother but paid for by debtor. In addition a fifth parcel, the "Thurston Circle Property," was transferred in 2003 by grant deed by debtor's son's godfather to "Edward W. Cutter, a Single Man" and a dispute existed as to whether this referred to debtor, Edward William Cutter II, or to his son, Edward William Cutter III.

The Bankruptcy Court's Rulings
Debtor filed a Chapter 7 case in July 2005. The trustee filed an adversary proceeding with many claims but the only one at issue in this appeal is for quiet title. On a motion for summary judgment by the trustee to quiet title in the trustee for both the Trust Properties and the Thurston Circle Property, the bankruptcy court granted the trustee partial summary judgment in holding that the Trust Properties belonged to the Chapter 7 estate, and denied summary judgment as to the Thurston Circle Property because of genuine issues of material fact about the intended grantee of that property.

The BAP's Holding and Rationale re the "Trust Properties"

Section 541 of the Code and Trusts
Since Debtor held title to the Trust Properties as trustee of the Trust, "under section 541(d), the corpus of the Trust would not be property of Debtor’s estate, unless he held an equitable interest in the Trust and its assets, or unless he could exercise powers over the corpus of the Trust for his own benefit." The BAP held that debtor did hold an equitable interest in the Trust as a beneficiary because he "possessed the right, at his sole discretion, to make distributions in order to provide for his health, education, or 'support and maintenance in [his] customary standard of living.' ”

Appropriate to Apply California Law on Self-Settled Spendthrift Trusts

The BAP observed that
California law invalidating efforts of a settlor from using a trust to shield property from his or her creditors applies “even where the settlor is not a nominal beneficiary, as where a settlor attempts to create a spendthrift trust for the benefit of his or her minor children, to be managed by the settlor and revocable at his or her pleasure.” (Citation excluded.)
And citing a Ninth Circuit opinion, the
critical inquiry in determining whether a spendthrift trust is valid under California law is whether the trust’s beneficiaries exercise excessive control over the trust.
. . . .
[Thus] under California law, a settlor of a spendthrift trust cannot also act as beneficiary of that trust (i.e., California law prohibits ‘self-settled’ trusts).
Since under the Trust Agreement the Debtor in his role as Trustee of his self-settled trust "could potentially use all of the Trust’s principal and income to maintain his standard of living," thus he exercised "excessive control" making the spendthrift trust invalid, and making the trust assets a part of his bankruptcy estate.

Section 541 Sufficient in Itself to Make Trust Assets Property of Chapter 7 Estate
Although generally "if only a portion of a spendthrift trust’s corpus is contributed by a beneficiary-debtor, only that portion becomes property of the beneficiary-debtor’s estate," "[i]f, . . . the trust agreement allows the debtor-beneficiary to exercise control over and reach trust property contributed by others, the estate is entitled to the maximum amount that the trust could pay or distribute to the debtor-beneficiary." Thus, since debtor had complete discretion regarding all of the trust assets, his "beneficial interest in all of the Trust corpus became property of the estate and Debtor’s power to use Trust assets for his benefit became property of the estate."

The BAP's Decision about the "Thurston Circle Property"

The trustee appealed the bankruptcy court's denial of summary judgment on this one parcel of property, but the BAP declined to hear the matter, based on Rule 54, Federal Rules of Civil Procedure.

Rule 54(a) and (b) are as follows:

Rule 54. Judgments; Costs
(a) Definition; Form.
“Judgment” as used in these rules includes a decree and any order from which an appeal lies. A judgment should not include recitals of pleadings, a master's report, or a record of prior proceedings.(b) Judgment on Multiple Claims or Involving Multiple Parties.
(b) Judgment on Multiple Claims or Involving Multiple Parties.
When an action presents more than one claim for relief — whether as a claim, counterclaim, crossclaim, or third-party claim — or when multiple parties are involved, the court may direct entry of a final judgment as to one or more, but fewer than all, claims or parties only if the court expressly determines that there is no just reason for delay. Otherwise, any order or other decision, however designated, that adjudicates fewer than all the claims or the rights and liabilities of fewer than all the parties does not end the action as to any of the claims or parties and may be revised at any time before the entry of a judgment adjudicating all the claims and all the parties' rights and liabilities.

The bankruptcy court had entered a partial summary judgment on the "Trust Properties" citing Rule 54, but that judgment specifically stated: "Other issues in this adversary proceeding remain pending and will be separately adjudicated.” Thus the bankruptcy court's Rule 54(b) determination did not reach the issues reached in trustee's appeal on the "Thurston Circle Property." The BAP stated that although it had discretion "to entertain interlocutory appeals from judgments that are not final," it chose not to because of the disputed factual issues about ownership of that property. Instead the BAP declined to accept jurisdiction and dismissed that portion of the appeal.

by Andrew Toth-Fejel
Bankruptcy Litigation Support for Attorneys
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