April 27, 2017

As I again read through the Delaware Court’s view in the recent Kloiber case about a Delaware trust that a divorcing spouse wanted to tap into as part of a divorce settlement, I could not help sense that the Delaware Court took every opportunity to suggest that Delaware law may not be available to protect the Delaware trust assets.

Even though the trust in question was not a self-settled trust, the issues raised by the Court could have easily been raised with regard to domestic asset protection trusts (“DAPTs”) too (which are typically self-settled). Many of the Court’s statements were therefore troubling in the sense that many proponents of DAPTs paint a picture of being very effective in providing sanctuary from creditor claims.

First, it should be noted that history has shown that DAPTs (other than in bankruptcy cases and cases that involve fraudulent transfers) can still be very effective in negotiating a settlement with a creditor that is more palatable to the debtor than what would have been achieved in the absence of the DAPT. Some of the comments by the Delaware Court, however, suggest that some chinks in a DAPT armor may become evident when analyzed by a court.
It should also be noted here that the chinks-in-armor would be less threatening if the trust in question had been an offshore trust created under the laws of a carefully-selected foreign jurisdiction, with the related-foreign court (to which I will refer as the “Foreign Court”) presiding over the matter.

In the Kloiber case, the Delaware Court specifically raised as a possible hole to the trust protections the ability and willingness of the Court to defer to another state’s laws to determine critical factors as to the protectiveness of the trust. For instance, in this Kloiber case, the Delaware Court did not look to Delaware’s protective trust laws, but instead looked to a Kentucky Court to address whether the debtor could release certain powers he held that would otherwise place at risk the trust assets to his creditor (who, in this case, was the debtor’s soon-to-be ex-spouse in a divorce).

A Foreign Court is much less likely or is unable to defer to the more creditor-friendly courts. In general, many Foreign Courts do not provide what is known as “comity” to other jurisdictions, meaning for our purposes here, the Foreign Courts do not recognize U.S. rulings that are contrary to the Foreign Court’s laws.
The Delaware Court also raised the issue that comes up many times in professional adviser conferences that discuss the possible shortcomings of domestic asset protection trusts. That issue is the U.S. Constitution’s “full faith and credit” clause that is applied to have one state respect the orders/rulings of another state’s court. This U.S. Constitutional provision, which of course trumps any state law, is very convenient to a court that prefers not to interfere with the non-protective state’s (here, Kentucky’s) legal process. In fact, the Delaware Court opinion in the Kloiber matter states that “this court also has no interest in having Delaware law deployed to defeat the marital property laws of another state.”

A Foreign Court is not subject to the application of the U.S. Constitution’s full faith and credit clause; hence the above results would not follow.
The Delaware Court also raised the issue of whether the assets transferred to the trust were accomplished in a way that qualified for protection. For example, the Court questioned whether the assets fell under the Delaware law’s definition of a “qualified disposition,” whether the creditor-spouse was allowed (under the Delaware statute) access to the trust as an “exception creditor,” whether the spouse was a creditor at all (and instead had other rights to the trust assets) and whether the debtor-spouse was ever able to effectively transfer the creditor-spouse’s interest in marital assets to the trust in the first place.

In the Foreign Court situation, history has shown that these issues have not been any sort of an Achilles heel under the foreign laws. The foreign trustee therefore stands in the position of not being forced to relinquish trust assets to a creditor.
To the Delaware Court’s credit, the Delaware Court did keep open the possibility that if the debtor-spouse were to lose in the Kentucky courts, then enforcing any such judgments in Delaware against the trust might still run into roadblocks. After seeing what the Delaware Court focused on and expanded upon in its opinion, however, this author did not get that warm and fuzzy feeling that the Delaware Court would become the final “safe place” for the debtor-spouse to land.

In the end, the parties did resolve the matter and the creditor-spouse received a significant settlement. Maybe the settlement was as favorable as it was to her because the debtor-spouse’s counsel also could not get that warm and fuzzy feeling?
If you have an interest in a more detailed list of the specific issues that the Delaware Court raised: (i) as justifications to defer to the Kentucky Court in addressing pertinent aspects of the trust; and (ii) as to the possible holes in the protective shell of the trust; please feel free to contact this author at edbrown@dslawcolorado.com

By Edward D. Brown, Esq., CPA, LLM

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