Contents

1. Homestead exemptions continue to be reliable but limited pre-bankruptcy planning devices
2. Personal property exemptions expand in variety and functionality
3. Conversion of non-exempt property into exempt property in the Ninth Circuit
4. Asset Protection Trusts take on new variations but also lack their former reliability
5. A new method in pre-bankruptcy planning
6. Caveat on the risks of exemption planning
7. Conclusion

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Among the common statutory property exemptions, the homestead exemption stands out because of its variance among the states and its potential for protection of large sums of wealth. Some states have an unlimited homestead exemption such as Florida, Texas and Oklahoma, while other states do not recognize a homestead exemption at all, including Maryland, New Jersey, Pennsylvania and Rhode Island. The rest of the states have nominal to moderate homestead exemptions.2

Congress recently attempted to pass new legislation in response to criticism of perceived inequities in state homestead exemptions. Initial discussions considered a uniform, national floor and ceiling approach. However, the House of Representatives, in its final proposed amendments to the bankruptcy statutes, decided to address the issue by increasing the residency requirements for a homestead exemption from 180 days to 730 days (2 years). Also in situations where the claimed homestead exemption would exceed $125,000, the House proposed to disallow a debtor's claim for the excess over $125,000, unless the debtor met an increased residency requirement of 1215 days (40 months).

Ultimately the bill did not pass, and so the usefulness of the homestead exemptions remains unchanged. Individuals seeking guidance from the recent actions of Congress should note that even if the bill were to pass, the framework would still continue to "both encourage and endorse forum shopping to preserve assets." For example, Congress did not attempt to change the federalism framework of homestead exemptions, in which states were allowed to opt out of federal homestead exemptions and craft their own instead. Therefore, forum shopping, homestead exemption planning will be a significant part of pre-bankruptcy planning for the foreseeable future.

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The usefulness of personal property exemptions in exemption planning should not be underestimated. A qualified retirement account is an example of why this might be so, since dollar sums protected in retirement accounts can potentially exceed those in all other categories, including homesteads. Personal property exemptions are also expanding in variety. For example in the formerly proposed bill, the House wanted to carve out a new exemption for qualified educational savings accounts for dependants. Furthermore, debtors filing in states that offer unusually high exemptions on particular items of personal property may have greater flexibility in using such exemptions. For example, in a recent Eighth Circuit decision the purchase of an exempt $10,000 shotgun for the sole purpose of exemption planning was permitted. Debtors should be warned that converting liquid assets into exempt personal property of "extraordinary value" might be risky, since state laws may apply special restrictions.

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Most often in order to utilize the exemptions, the debtor must convert non-exempt assets into exempt assets. Debtors with cash may put the funds it into a qualified retirement account, pay down a mortgage on an exempt homestead, or purchase an item of exempt personal property. Debtors without cash on hand may liquidate non-exempt assets in order to generate cash. To avoid triggering a fraudulent transfer, such sales must be for fair market value and sold to persons who are not insiders. In Wudrick, the Ninth Circuit even permitted debtors who obtained loan funds by offering non-exempt vehicles as security to deposit such funds into an exempt account before declaring bankruptcy.

After such a transfer, creditors of the debtor, either individually or by the representation of the bankruptcy trustee, would likely try to unravel these transfers in order to satisfy their claims. Successful unraveling of the transfer requires establishing actual or constructive fraud. A showing of "badges of fraud" in a particular fact pattern may be sufficient evidence of constructive fraud. However, in Wudrick, the Ninth Circuit held that the sole act of converting nonexempt assets to exempt assets is not in itself a badge of fraud.

Generally, the Ninth Circuit has taken a very debtor-friendly position by allowing intelligent exemption planning, even on the eve of bankruptcy. For example in a recent case, bankruptcy Judge Randolf J. Haines sought to distinguish three different categories of "badges of fraud" based upon their degree of severity. He itemized first those badges of fraud that are "indicative of concealment, deception, or fraudulent intent" such as a debtor's retained possession or control of the property after transfer, a concealed transfer, the debtor absconding, or the concealment of assets. A second category consists of less severe "badges of fraud" that do not suggest outright fraud but rather imply a non-economic rationale, such as the transfer to an insider, less than full consideration received by the debtor for the value of the asset transferred, or the debtor transferred the essential assets of the business to a creditor who retransferred the assets to an insider. The third category consists of the least severe "badges of fraud," timing factors. Timing factors are innocent in themselves but only become suspicious when combined with other factors. Examples of such timing factors include the debtor was threatened with suit before the transfer was made; the transfer was of substantially all the debtor's assets before petition for bankruptcy; the debtor was insolvent or became insolvent shortly after the transfer; or the transfer occurred shortly before or shortly after a substantial debt was incurred.

Judge Haines asserted that the "badges of fraud" in the second and third categories only showed intent to convert a nonexempt asset into an exempt asset. Accordingly, such intent was not sufficient to sustain a summary judgment or even to shift the burden to the debtor in a trial. Transfers with badges of fraud in the second and third categories only demonstrate that the debtor engaged in permissible exemption planning when it was intelligent to do so and that the debtor was willing to sacrifice some asset values to achieve the exemption.

Therefore, the first category of the "badges of fraud" is most relevant towards a finding of fraudulent intent. In order for a debtor action to qualify as a first-category action, the creditor must show a deception or concealment; a fraudulent conveyance with a secretly retained possession or benefit; or that the debtor's explanations lack credibility. Debtors who are candid at all times and who openly admit when questioned to exemption planning motives will likely avoid having their actions cast into the first category. On a similar note, debtors should avoid converting major nonexempt assets into cash on hand because such large sums imply concealment, another first-category offense. Rather, the debtor should immediately convert cash on hand into exempt assets.

Unfortunately, debtors filing in circuits other than the Ninth Circuit will have less certainty about the validity of their transfers. For example, the Eighth Circuit noted in an oft-cited case that "when pigs become hogs they get slaughtered" and attempts to ascertain if the amount exempted through intelligent planning is quantitatively "too much." In that case, the debtor Tveten liquidated "almost his entire net worth of $700,000 and converted it to non-exempt property in seventeen transfers on the eve of bankruptcy." The bankruptcy court concluded from Tveten's "entire pattern of conduct" that Tveten had demonstrated fraudulent intent, which was later affirmed by the district court and the Eight Circuit court. Central to the Eight Circuit court's decision was the fact that the debtor Tveten only earned $60,000 annually. The Court was concerned that, by permitting the debtor to retain a $700,000 exempt asset that was abnormally large relative to his salary, Tveten would receive a "head start" rather than a "fresh start." Therefore, the majority denied Tveten the exemption and unraveled the transfer. In the dissent, Judge Arnold believed that debtor Tveten did nothing more than "exercise a prerogative that was fully his under law." Judge Arnold argued against the majority's use of the principle of "too much." In another Eighth Circuit case, the court claimed to require a showing of extrinsic factors of fraud before finding a fraudulent transfer. However, the Court then went on to rely on factors such as the debtor's age and the value of a transferred house, which arguably are not extrinsic factors, in finding a fraudulent transfer.

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Planning involving Asset Protection Trusts (APTs) differ from previously mentioned exemption planning in that forum shopping in the APT context requires only that a trust's situs be carefully selected, whereas "forum shopping in the exemption context requires a change of domicile." APTs usually fall under one of three categories: 1) traditional spendthrift trust with third party beneficiaries; 2) offshore asset protection trusts with settlor as the beneficiary (OAPTs); and 3) domestic asset protection trusts with the settlor as the beneficiary (DAPTs). In a sense, both OAPTs and DAPTs are merely a subset of spendthrift trusts. They differ from a traditional spendthrift trust in that the OAPT or DAPT are self-settled and contain an anti-alienation provision, which may be triggered upon special events such as the duress of the settlor. Other examples of common OAPT or DAPT provisions include a forfeiture provision; or a beneficial interest that is restricted from transfer by the beneficiary, such as a beneficial interest for support-only. A forfeiture provision functions by terminating the beneficiary's interest if an attempt is made to alienate the beneficiary's interest; therefore, a creditor's attempt to seize the debtor's interest in the trust will likely trigger the forfeiture provision and thwart the collection attempt.

(A). A traditional spendthrift trust with third party beneficiaries is still the best form of Asset Protection Trust.

A traditional spendthrift trust is still a more reliable form of asset protection than OAPTs or DAPTs. For example, the District Court for the Southern District of New York, in ruling on a debtor who made transfers to both a traditional spendthrift trust and an OAPT, only upheld transfers to the traditional spendthrift trust and unraveled the transfers to the self-settled OAPT. The court, offended by the fact that the OAPT was offshore and self-settled, found badges of fraud in the transfers to the OAPT. The result was not unusual since most jurisdictions, in applying their own state law, will allow creditors to pierce a self-settled trust. Unfortunately, a primary feature of OAPTs and DAPTs is the fact that they are always self-settled. In contrast, the traditional spendthrift trust, which only designates third-party beneficiaries and traditionally serves the purposes other than exemption planning, is almost universally respected.

(B). Choice of law is a key factor in the efficacy of DAPTs and OAPTs.

If the court applies the law of the state in which the DAPT is situated then such a DAPT is likely an effective asset protection device. A federal bankruptcy court is required to recognize non-bankruptcy laws when determining if a transfer was fraudulent or not. In other words, the federal bankruptcy court must apply the proper state laws. However, if the court applies the law of a non-DAPT state, a state without DAPT statutes, then there is a high risk that the DAPT structure will not be respected. The primary reason for this is that most non-DAPT states prohibit self-settled trusts. Also, both DAPT and non-DAPT states may permit creditor piercing at a certain dollar amount or may refuse to enforce trust provisions if the creditor claim is for spousal support.

The ideal scenario for an effective DAPT is one in which the debtor-settler, trustee, and creditors are all domiciled in the DAPT state. In such a case, the favorable DAPT state laws will likely apply. However, part of the convenience of utilizing a DAPT rather than a homestead exemption is that the debtor is not required to change his or her domicile. The debtor must make a choice as to whether or not relocating to the DAPT state is worth the benefit. Debtors that rely solely on the fact that the DAPT trustee is a domicile of the DAPT state may be taking a substantial risk. Personal jurisdiction over the trustee could be found if the trustee had minimum contacts with the forum state and that if such jurisdiction was foreseeable. If a forum court of a non-DAPT state had personal jurisdiction over the DAPT trustee then the forum court could likely apply the choice of law of the forum state, rather than the favorable DAPT state laws.

Choice of law is especially important for OAPTs. If a court applies the law of the foreign jurisdiction in which the OAPT is situated then such an OAPT has a greater chance of being effective. Typically, the laws of OAPT countries allow the trust to be self-settled and controlled by the settlor through a non-binding letter of intent to the trustee. Also, the trust instrument can contain a choice of law provision applying only the law of the foreign jurisdiction; include an anti-duress provision that would remove any powers retained by the settlor; have a flight clause that enables the movement of the trust from one jurisdiction to another in the event of litigation; and have a provision that allows the settlor to regain control after the threat had passed. The efficacy of OAPTs depends on the application of these special collection-blocking laws.

(C). Factors contributing to the decline of OAPT effectiveness.

First, OAPT creators unwisely rely on the assumption that the choice of law of the foreign jurisdiction will apply. However, courts will often ignore the laws of the expressly chosen jurisdiction when they conflict with the forum state's public policy. A District of Connecticut bankruptcy judge explained, "Connecticut courts generally respect the expressed will of the settlor of a trust as to the controlling law #8230; There are, however, exceptions. #8230; Connecticut will not enforce the law of another jurisdiction nor the rights arising thereunder, which contravene Connecticut public policy." The bankruptcy judge was particularly concerned about the fact that the OAPT was self-settled and Connecticut law prohibits such self-settled trusts. The Court went on to find that Connecticut law, rather than the foreign law applied because "stock certificates [held by the OAPT] are personalty, the settlor resides in Connecticut, and on the basis of public policy considerations." In another case, the District Court for the Southern District of New York applied a balancing test and found that

[Debtor's] creditors [had] no contacts with Jersey [the offshore situs of the trust], and [the debtor] had the greatest contact with the United States at the time he settled the trust and reasonably could have believed that United States law would be applicable #8230; [o]n balance, I conclude that New York has the weightier concern in determining whether or not whatever rights [debtor] retained after he formed the trust #8230; [I]n addition, I believe that application of Jersey's substantive law would offend strong New York and federal bankruptcy policies if it were applied.

Therefore, the whole OAPT can be pierced by a finding that the trust violates a state's public policy, such as a violation of the state's rule against self-settled trusts.

Second, courts are becoming increasingly bold in enforcing collections on a pierced OAPT. For example, in Affordable Media the Ninth Circuit set a precedent when it denied the debtor's defense that he retained no control over the OAPT and found the debtor in contempt for failing to repatriate trust assets. The Ninth Circuit court explained its disbelief in the creditor: "[w] hile it is possible that a rational person would send millions of dollars overseas and retain absolutely no control over the assets, we share the district court's skepticism." The Eleventh Circuit followed the Ninth Circuit and also held a debtor in contempt for failing to repatriate offshore trust assets. The Eleventh Circuit court disposed of the debtor's claim of impossibility on a variety of grounds, one of them being a finding that the trust indenture did not structurally deprive the debtor of control. The OAPT instrument was defective in that it allowed for the debtor's control "through his retained powers to remove and appoint trustees and to add and exclude beneficiaries" and the trust did not state whether the exclusion of the debtor was irrevocable. In other words, the OAPT trustee had discretionary powers to revoke the debtor's exclusion decision.

The suggestion that a better-planned trust could have tied the court's hands should be dismissed. The Eleventh Circuit held that "[e]ven if we were to find that [debtor] had set forth sufficient evidence of impossibility, we must agree with the trial court that [debtor's] claimed defense is invalid because the asserted impossibility was self-created." Another court in an earlier proceeding remarked that, "[g]iving credence to the Debtor's argument would be tantamount to succumbing to the pleas for sympathy from an orphan who has killed his own parents."

The bankruptcy court may use means other than contempt in exacting compliance from the debtor. In an earlier mentioned case, the judge of the Bankruptcy Court for the District of Connecticut ruled against a debtor's offshore trust based on choice of law rules. However, if the debtor were to fail to comply with the judge's order to repatriate trust assets, including the stock of a Connecticut corporation, then the judge may have another option of enforcement. Some commentators suggested that the court, under Connecticut law, could have ordered the Connecticut corporation's shares in the trust be cancelled and then order the corporation to issue new shares.

Third, an interesting new development in this field is the new subspecialty of lawyers who specifically represent creditors attempting to collect from OAPTs. In fact one former promoter of OAPTs, Ronald Rudman, the former partner of OAPT promoter Barry Engel, has gone to the other side and now "buys up seemingly hopeless claims against people who have offshore trusts and sets about to collect them." Perhaps the next boom in this industry is the work of piercing these OAPTs.

Fourth, the fact that many of the commercial sites offering OAPTs are now in their own trouble is disconcerting. Here the character of the financial advisor creating the OAPT is the issue. For example, Jerome Schneider, a well-known promoter of OAPTs, recently was co-indicted with his partner by a federal grand jury in December 2002. They were charged with conspiracy and 22 counts of mail and wire fraud. Furthermore, there are various schemes that are marketed as OAPTs but are in reality nothing more than scams to entice debtors to send money to an oversea con artist.

In favor of OAPTs, it should be noted that other governmental agencies have not aggressively targeted these trusts if they were used solely for an asset protection purpose, rather than a tax evasion-purpose. Lately, the IRS has been aggressively attacking such tax evasion OAPTs, and they appear to be successful in many cases.

Views on the future of OAPTs vary among commentators. One commentator suggests that presently the reliability of an OAPT as an asset protection device is likely no worse than a DAPT. However, an article in Forbes went so far as to assert, "any offshore trust with U.S. assets is a prescription for disaster."

(D). DAPTs function much like their offshore counterparts but show more promise as a reliable asset protection shelter.

Recently, several states have passed statutes authorizing trusts with important similarities to OAPTs. For example, a 1997 Alaska statute extends new protections to debtors by 1) permitting a spendthrift trust to be self-settled; 2) allows an anti-alienation clause which restricts transfers to creditors; and 3) restricting the time period in which creditors can challenge the transfer. Since Alaska's move in 1997, Delaware, Nevada, and Rhode Island have also followed suit in adopting their own DAPT legislation. The laws vary among the states and potentially pose a situation of a race to the bottom, in which the states compete by sacrificing creditor protections. For our purposes we will examine the structure of the Alaska DAPT.

Alaska Statute §34.40.110 allows a transfer restriction provision in the trust which "prevents a creditor existing when the trust is created, a person who subsequently becomes a creditor, or another person from satisfying a claim out of the beneficiary's interest." The transfer restriction gives the trustee a first priority to the interest of the beneficiary. The effect is that the interest is unreachable either voluntarily or involuntarily by anyone other than the trustee.

Alaska Statute §34.40.110(b) lists four basis upon which such a trust may be pierced: 1) the transfer by the debtor into the trust was a fraudulent transfer; 2) if the trust is revocable by the settlor; 3) if the trustee must, rather than may, distribute trust funds to the settler; or 4) if at the time of transfer a claim of child support was pending upon the settlor. Creditors, wishing to challenge the trust, must bring an action to void the transfer within one year after the transfer could have been reasonably discovered by the creditor. Note that this restriction on the time limit is not unique, for example the bankruptcy trustee under federal law, may also reach back up to one year to avoid transfers.

However, Alaska Statute §12.36.310 specifically states that transfers are not void "on the grounds that the trust or transfer avoids or defeats a right, claim, or interest conferred by law on a person by reason of a personal or business relationship with the settlor or by way of a marital or similar right." In other words the mere use of this trust, even for a bankruptcy planning or creditor avoidance purpose, is not enough to show a fraudulent transfer. This is a codification of the Ninth Circuit rule. Some commentators wondered whether, in light of this statute, the Alaska courts would even continue to use "badges of fraud" in finding constructive fraud. However, in a very recent Alaska Supreme Court case it was shown that the "badges of fraud" are still applicable in finding constructive fraud.

A unique characteristic of DAPTs, compared with OAPTs, is that DAPTs do consider the nature of the claim. For example, Delaware will allow the DAPT to be pierced for claims of spousal and child support. Alaska will allow DAPT piercing for child support if the debtor is more than 30 days delinquent on a child support judgment at the time of transfer.

Another unique characteristic of Alaska DAPTs is the built-in lawyer protection. Specifically, a creditor is prevented from asserting a cause of action against the trustee or lawyer involved in the preparation or funding of the trust. Creditor recourse is "expressly limited in such cases to the settlor and, to the extent the conveyance was fraudulent, the trust assets."

A decision against a DAPT by any United States court is entitled to full recognition, even in the DAPT situs state, by the full faith and credit clause. This means that courts applying non-DAPT state law can bypass Alaska's DAPT laws and pierce Alaskan DAPT provisions. Alaskan courts must honor such a piercing. In contrast, OAPTs enjoy the advantage of not being subject to the full faith and credit clause. Any actions aimed at a debtor's OAPT must be litigated or re-litigated in the respective courts of the offshore jurisdictions. Furthermore, the laws of the OAPT jurisdiction are often more debtor-friendly. Some examples of debtor-friendly laws found in these offshore jurisdictions include high burdens of proof for the creditor trying to pierce the OAPT, short statute of limitation periods, and the customary requirement of up front attorney's fees prior to any action against a party.

Overall, an Alaska DAPT may show slightly more promise than OAPTs as an asset protection vehicle for two reasons. First, the debtor can take pro-active steps such as relocating to the DAPT state of Alaska in order to ensure that the proper choice of laws is applied. True, a debtor could also relocate to an offshore island to ensure that the proper OAPT laws are applied but that is certainly a more extreme step. Second, Alaska DAPT laws expressly prohibit recourse against the pre-bankruptcy planning lawyer for preparation or funding of the DAPT. However, the complexity of the foreign laws supporting OAPTs may intimidate creditors into settling claims rather than pursuing collection.

Aggressive use of either DAPT or OAPT, especially after a judgment has been entered, will likely result in a piercing of the APT by the bankruptcy court. However, current DAPT laws do not limit the amount the debtor can store in the trust. One commentator noted that Congress at an earlier point had the option of choosing national-uniform limitations on spendthrift trusts based on "reasonable support needs," but instead Congress did not act for unspecified reasons. Perhaps Congress favored the principle of freedom of disposition of property.

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Jeffrey Golden in an article in the California Bankruptcy Journal describes the utilization of a newly discovered loophole for purposes of exemption planning. Two cases decided by the Ninth Circuit in 2000 held that a conversion to Chapter 7 does not trigger a new time period for an objection to an exemption. In other words a debtor could file under Chapter 11 and wait until the period for objections to exemptions expire, and then convert to Chapter 7. During the objection period, the debtor is the DIP. The later trustee appointed in Chapter 7 is bound by the acts of the debtor-DIP. Therefore the debtor-DIP could fail to object his or her own transfers and then prevent the later bankruptcy trustee from objecting afterwards, since the period for objections had expired.

"[A] debtor might file Chapter 11 contemplating conversion to Chapter 7 after the thirty-day objection period passes. The debtor may assert a frivolous or extreme interpretation of the exemption statute with the hope that creditors will not timely object prior to conversion since there is no trustee, and smaller creditors with smaller claims might not be that aggressive. If a few creditors have a large stake, the outcome might be different. But a typical case may have multiple creditors with small to medium claims. Uncertainty about the outcome of an objection and its effect on the administration of the estate combined with cost considerations might result in minimal or no action by the creditors."

Debtors should be warned that this method has not been tested in the courts yet. Also the proposed method may be susceptible to the doctrine of equitable tolling as a defense to the expiration of the time period.

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Possible risks of pre-bankruptcy exemption planning include: 1) unraveling the transfer and recapturing the assets for the estate; 2) denying the debtor's discharge; 3) separate sanctions for debtor and pre-bankruptcy planner; and 4) debtor may be held in contempt if he or she cannot turnover assets of a DAPT or OAPT.

Some exemption planning is lawful and some is not. Lawyers that participate in unlawful exemption planning violate the Model Rules of Professional Responsibility 1.2(d), which states that a lawyer shall not encourage a client to engage in fraudulent conduct. Furthermore the creditor may have a cause of action against the debtor's counsel for unlawful asset protection.

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The result is a give and take. Generally, the law is foreclosing abusive exemption practices while broadening the range of benign practices. Perhaps in the near future, when the details of legitimate pre-bankruptcy exemption planning are hammered out, such planning could be as accepted and as commonplace as estate or tax planning.