Self-settled spendthrift trusts: should a few bad apples spoil the bunch?

• Author: Rothschild, Gideon
• Position: The Rise of the International Trust

The bankruptcy courts' 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 nonbankruptcy 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 section 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)

1. 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 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] [sections] 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 weal."(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 Restatement (Second) of 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.

2. 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 u. 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 "[lit 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 a 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 27'3. 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 nonsequitur. Although application of the foreign law may...