When Estates Collide: A Discussion of the Intersecting and Conflicting Interests of a Debtor’s Bankruptcy Estate When She is Also a Spendthrift Trust’s Beneficiary

By Selwyn D. Whitehead, Esq.

A. Introduction

There has been a head-on collision in California courts concerning the equitable interpretation of Sections 15300 -15309 of the California Probate Code when juxtaposed against the Bankruptcy Code and the case law bankruptcy courts must analyze to determine the maximum interest, if any, a debtor’s bankruptcy estate can access and take from a debtor-beneficiary’s interest in third party’s asset protection trust, also known as a “spendthrift trust.” Finding contradictory and confusing language on the subject in the California Probate Code and no controlling California Supreme Court or Court of Appeal precedent on point, on appeal from the Ninth Circuit B.A.P., the U.S. Court of Appeals for the Ninth Circuit certified the following question to the California Supreme Court on March 9, 2015.

Does section 15306.5 of the California Probate Code impose an absolute
cap of 25 percent on a bankruptcy estate’s access to a beneficiary’s interest
in a spendthrift trust that consists entirely of payments from principal, or
may the bankruptcy estate reach more than 25 percent under other sections
of the Probate Code?

On March 11, 2015, the California Supreme Court accepted the certified question. The matter has been fully briefed, with oral arguments set for January 4, 2017. Frealy v. Reynolds, No. 12-60068 (“In re Reynolds” or “Frealy”).

As can be gleaned from the call of the certified question, at issue in Frealy are the debtor-beneficiary’s (“Reynolds”) claims that California Probate Code section 15306.5 caps the bankruptcy estate’s access at 25 percent of Reynolds’ beneficiary interest in his late parents’ trusts, which consists entirely of payments from principal. While the bankruptcy trustee (“Frealy”), seeks to reach much more than 25 percent of the beneficiary’s interest under Probate Code sections 15301(b) and 15307, which the trustee argues are not subject to the section 15306.5 cap of 25 percent. [See Order at pg. 3.]

B. The Pertinent Facts and Law of the Case as Stated in the Underlying Bankruptcy Case [See In re Reynolds, 479 B.R. 67, 70-71 (9th Cir. BAP 2012)]

In 2005, Rick Reynolds’s (“the Debtor”) parents, Freddie Hugo Reynolds (“Freddie”) and Patsy R. Reynolds (“Patsy”), established the Reynolds Family Trust. Patsy died in November 2007. Upon her death, the Reynolds Family Trust was split into three sub-trusts: (a) the Bypass Trust; (b) the Marital Trust; and, (c) the Survivor’s Trust.
Freddie retained the right during his lifetime to receive all the income from each of the trusts. While the Bypass Trust and the Marital Trust (together, the Family Trust) were vested, became irrevocable and were no longer subject to further amendment, the Survivor’s Trust (“Survivor’s Trust”) was under control of Freddie and was amended from time to time by him until his death on March 3, 2009.

Once the Debtor survived Freddie by 30 days, he was entitled to receive distributions from the Family Trust and the Survivor’s Trust. From the Family Trust, he was entitled to $250,000. Additionally, the Debtor was a one-third beneficiary of the Survivor’s Trust, along with his sisters, entitled to receive $100,000 per year for 10 years. The assets in the Survivor’s Trust are interests of undeveloped real property, which do not generate income. Thus, the distributions to the Debtor are expected to be paid from trust principal. The terms of the last amended Survivor’s Trust provided that after the Debtor survived Freddy for ten years, he would receive a final distribution of one-third of the remaining principal. Although the exact amount of the Debtor’s interest in the Survivor’s Trust is unknown, the bankruptcy trustee believes it could be as much as several million dollars.
The Family Trust and the Survivor’s Trust are “spendthrift” trusts, containing provisions that “[n]o interest in the income or principal of any trust created under this instrument shall be voluntarily or involuntarily anticipated, assigned, encumbered, or subjected to creditor’s [sic] claim or legal process before actual receipt by the beneficiary.”

The Debtor filed a voluntary chapter 7 petition on March 4, 2009 . Sandra L. Bendon was appointed the chapter 7 bankruptcy trustee (the Trustee) .

On April 28, 2009, John Carmack, sole trustee of the Family Trust and co-trustee, with John Morris, of the Survivor’s Trust, filed an adversary proceeding seeking a declaratory judgment determining whether and to what extent the bankruptcy estate held an interest in the Family Trust and the Survivor’s Trust.

On January 14, 2010, the Debtor filed a motion for partial summary judgment (MSJ). The Debtor sought a partial summary adjudication and judicial declaration that pursuant to California Probate Code §§ 15300 et seq., particularly 15306.5, a maximum 25% of a beneficiary’s interest in a spendthrift trust is property of a bankruptcy estate. Therefore, the Debtor argued that the bankruptcy estate was entitled to reach no more than 25% of the Debtor’s interest in the Family Trust and the Survivor’s Trust.

The Trustee opposed the MSJ. The Trustee acknowledged that Probate Code 15306.5 capped a judgment creditor’s recovery at 25% of a beneficiary’s interest in a spendthrift trust. However, she (Bendon, Frealy’s predecessor) argued that distributions of principal amounts payable to a beneficiary under a trust, even if the trust contains a spendthrift provision, are not protected under Probate Code 15301(b) . Thus, the Trustee asserted that because the distributions from the Family Trust and the Survivor’s Trust were expected to be made from principal, the bankruptcy estate could potentially reach all of the Debtor’s interests. Alternatively, the Trustee asserted that, under Probate Code 15307, the estate could reach the Debtor’s interest in all amounts from the Family Trust and the Survivor’s Trust over and above what he required for his education and support.

At the hearing on the MSJ, the bankruptcy court disagreed with the Trustee’s interpretation of the Probate Code. It interpreted the Probate Code as allowing the estate a maximum of 25% of a debtor’s interest in a spendthrift trust, less any amount the debtor needed for his support or support of his dependents. The bankruptcy court entered its order granting the MSJ on June 6, 2011. A final judgment was entered on July 29, 2011. The Trustee timely appealed to the BAP.

C. So, What Does All This Legalese Mean in Plain English?

Among other things, it is Frealy’s position that pursuant to Cal. Prob. Code § 15301(b) inasmuch as Reynolds has an interest in a self-depleting terminating trust and not an income-producing, long-term trust, Frealy should have the right to have the court confirm his right to wrest control of Reynolds’s interest in the trust from Carmack now, in that the principle amount to be distributed to Reynolds is an identified amount that is “due and payable” according to the trust instrument’s own terms. While on the other hand, Reynolds and Carmak claim that Frealy’s position is incorrect in that section 15301(b) has historically been used as the mechanism to pay creditors from the residual of principal after a trust has completed its lifespan and has paid out its bounty to the beneficiaries over time and is therefore ready to be wound down, which is not the case here, as the trust contains a 10-year payout period to Reynolds.

It is also Frealy’s position that he has an alternate route to an unlimited portion of Reynolds’ beneficiary interest that the court should confirm now is via section 15307, which allows a creditor to attach any amount of a beneficiary’s trust distribution that is not necessary for the education and support of the beneficiary, alleging that there is no way, no how Reynolds has a need for $1,250,000.00 over the next 10 years. Reynolds, of course, demurs to Frealy’s contention about Reynolds’ financial needs.

D. What are the Broader Implications of Frealy for Today’s Bankruptcy Practitioner?

Trust administration is hard enough under most the most ideal circumstances. For example, angry omitted family members or former intimates of the now deceased settlor frequently come forth demanding some part of the trust corpus. Or a trustee responsible for administrating the now deceased settlor may need to sue one or more parties to recover fraudulent transfers that may have occurred when someone took financial advantage of the settlor during her incapacity or decline in cognition. These eventualities make trust administration work at least emotionally taxing for the successor trustee and her professionals.

However, when a party not contemplated in the trust instrument comes forth demanding some or all of the trust corpus under legal theories that were not contemplated under the California Probate Code when the trust was created, bearing the imprimatur of the bankruptcy court and the Office of the United States Trustee, trust administration can suddenly turn into a nightmare scenario, resulting in the unanticipated depletion of the trust corpus through defense costs.

In addition to the Settlor’s own final expenses and moneys due her own creditors and the trust administration professionals who need to be paid from trust estate’s income and/or principal, in a bankruptcy scenario, some of the other parties vying for dominion and control over some or all of the corpus of a 3rd Party’s Trust now could include: (1) a chapter 7 trustee (“Ch7Trustee”) acting as the guardian of the bankruptcy estate’s (“the Bankruptcy Estate”) unsecured creditor class, or (2) a chapter 13 trustee (“Ch13Trustee”) acting in a similar capacity for at least the first 180 days after filing the case, (3) the bankrupt Debtor (“the Debtor”) who is or becomes a beneficiary (“the Beneficiary”) of a Third Party’s Trust while the bankruptcy case is pending, and, (4) the Third Party’s Trust’s Successor Trustee (the “Successor Trustee”), who is responsible for both (a) protecting the Settlor’s absolute right to control the distribution of her own hard-earned assets “from the grave,” and (b) preserving and protecting the rights and interests of the Third Party’s Trust’s Beneficiaries. In some instances, the Debtor is also both a beneficiary and the successor trustee .

In my own bankruptcy practice for the last few years I am finding that in addition having to investigate whether a potential client has created her own self-settled trust, I must also investigate whether she is a party to her parent’s or grandparent’s or siblings’ or other Third Party’s revocable or irrevocable trusts or if she holds a financial power of attorney for a third party, if she even knows. If I find that she is either a trustee, potential trustee or beneficiary of a third party’s or parties’ trust or is the attorney-in-fact for a third party in some capacity; I must also counsel this potential client on the fundamentals of estate planning law, in general, and trust administration law and/or her duties as an attorney-in-fact under the California Probate Code, in particular. I must also warn her how her status relative to the provisions of express or resulting trust she is associated with could impact her bankruptcy case including the potential threat by an aggressive bankruptcy trustee to take control of the property of others she controls if she decides to file. This estates and trust and probate code counseling, in addition to all the other pre-filing issues counseling that must normally be provided by competent bankruptcy counsel must be provided to the potential client prior to her decision to file a chapter 7 liquidating bankruptcy.

And as is the case here, because a debtor’s relationship to a third party’s or parties’ trust may not have been perceived as an issue or even known about prior to the filing of a case under either a liquidating or one of the reorganizing chapters, due to the extended time the debtor finds herself in bankruptcy, if a Settlor has designated the Debtor as either a Successor Trustee or Beneficiary of the Third Party’s Trust, and subsequent to the filing of the bankruptcy, the Settlor dies or become incompetent, I must be able to assist the Debtor in standing up to a potential challenge of a bankruptcy trustee that may be brought against the Debtor’s beneficiary interests in the wake of this little known but extremely important case now pending before the California Supreme Court.

E. Why are the Issues Uncovered by In re Frealy of Such Heightened Importance Today?

As our county’s heretofore middle-class hourly-wage-earning class continues to experience the 30-plus-years of wage stagnation coupled with their parent’s baby boom generation’s continued march into oblivion, after hopefully only a brief stop in dementia-land, an increasing number of these financially-strapped individuals are finding themselves in their 50s and 60s and sometimes 70s when they come to the inevitable conclusion that they need to seek the protection of a bankruptcy court to deal with their ever-shrinking buying power and ever-mounting debt.

The reasons are straightforward; these middle-aged and former middle-class debtors are shackled with financial obligations that cross the full spectrum of their age-related obligations owed to their own family members.

Firstly, these debtors are dealing with the financial and emotional obligations related to launching their children (and more and more often their grandchildren) into adulthood. Secondly, these debtors are dealing with the financial and emotional obligation of aiding their aging parents who may need assistance managing their own emotional and financial affairs as these seniors transition the various stages of cognitive deterioration. And finally, these debtors are dealing with their own deteriorating finances with limited upside income potential.

As a legitimate means for handling our prospective future financial obligation as we age, for at least the last few generations estates and trusts professionals have extolled the virtue of setting up revocable or irrevocable trusts with spendthrift provisions. Again, a spendthrift provision simply states that the assets of the trust cannot be alienated from the Settlor’s trust estate either voluntarily by a Beneficiary or involuntarily by one or more of the Beneficiary’s creditors, with limited exceptions specifically articulation in the California Probate Code. As such, these trusts have been used as legitimate tools to grow over time a Settlor’s assets with some favorable tax treatment and if set up properly to limit the access of most creditors to the Settlor’s assets and thereinafter allow the Settlor to make periodically inter vivos transfers of some of her assets to her loved ones during her capacity and/or all of the assets to her progeny, or the others intended to receive the bounty of her wealth at her incapacity or passing – all done with limited public scrutiny or court supervision. These are not new concepts, as trust law limiting creditors’ access to a beneficiary’s interest via a spendthrift provision has existed in California in some form or fashion since 1872.

However, if the debtor’s parents or grandparents, the Settlors, have set up a trust, especially one with a valid spendthrift provision, that either is at inception or becomes irrevocable upon incapacity or death of the Settler(s), such a trust may turn out to be only a first step in preserving the Settlor’s assets and making sure the assets are distributed according to the Settlor’s wishes. Unfortunately, I have begun to observe in the run up to and in the wake of Frealy that a valid spendthrift provision may no longer be enough to assure that the Settlor’s wishes are not waylaid by an aggressive bankruptcy trustee when the former middle-case Debtor realizes that as a tangible reflection of the love and affection her parents or grandparents have for her and her children, the Settlor or Settlors have set up a trust to provide assistance to the Debtor and sometimes more importantly, the Debtor’s progeny.

F. Conclusion

In the wake of the Frealy dispute, a lot of jurists and lawyers have and continue to sort through and grapple with the bankruptcy estate and third-party-trust-related parties-in-interest’s rights and limitations ambiguities that have emerged from their review and analysis of California Probate Code. These identified ambiguities must be resolved before the bankruptcy court can arbitrate the competing interests held by the multiple parties involved in the administration of the asset protection trusts at issue here. The resolution of the ambiguities in Frealy will have far reaching implications for all asset protection trusts that are in place or in contemplation now, or are developed in the future.

As a result of Frealy, a Debtor may have to face down a real threat from an aggressive trustee wanting to invade some or all of the income and principal of the newly deceased or incompetent’s third party’s or parties’ asset protection trust for the benefit of the bankruptcy estate and it’s unsecured creditors. As we can see, this collision of the competing estates’ interests may occur even when the third party’s or parties’ asset protection trust contains a valid spendthrift provision and even if the results of the trustee’s aggression inures to the detriment of and is contrary to the expressed plan of distribution articulated by the Settlor’s in her now irrevocable trust.

In my capacity as an advocate for a Settlor’s rights to do what she wants with her own assets, I am also concerned that in a trial court’s sometimes laser focus on balancing the rights of the Debtor-beneficiary versus the rights of her creditors, the court may too greatly discount the wishes of the party that created the wealth in the first place – the Settlor. As a result, I’m interested in the lessons that can be learned from this dispute about what a Settlor must do prior to the trust becoming irrevocable to make sure her wishes, and not those of a bankruptcy trustee, are fulfilled.

As I have several pending bankruptcy cases that implicate some or all of the complex third party Trust-related issues to be decided by the California Supreme Court in Frealy, I intend to attend the Court’s oral arguments on January 4, 2017 and take notes. In a subsequent submission to this publication, I intend to share my observation of the issues raised by the Court at oral arguments with this audience.

 


About the Author:  Selwyn D. Whitehead, Esq. practices bankruptcy and tax law at the LAW OFFICES OF SELWYN D. WHITEHEAD in Oakland.

Selwyn’s practice focuses on helping her clients manage their wealth through effective estate and tax planning and/or manage their debt through debt restructuring or bankruptcy. Selwyn also helps her clients facing foreclosure and represents clients before the Franchise Tax Board, the IRS and the U.S. Tax Court. Prior to going into private practice, Selwyn managed a group of attorneys and paraprofessionals in Fireman’s Fund Insurance Company’s Claims Department. Before joining Fireman’s Fund, Selwyn spent 17 years as a financial services industry consumer advocate. She held leadership positions at the Law Offices of Public Advocates and The Greenlining Coalition, focusing on banking and insurance public policy issues; was a consumer representative to the California Automobile Assigned Risk Plan, the California automobile insurer of last result; and, founded the non-profit Economic Empowerment Foundation, whose mission was to educate urban center dwellers, small business owners, and women about their rights and responsibilities as financial services industry consumers, while advocating on their behalf before regulatory and governmental bodies, including Congress and the California Legislature. Between 1993 through 1998, Selwyn was selected by the Officers of the National Association of Insurance Commissioners to represent the interests of California insurance consumers before that body.

Selwyn obtained her J.D. from New College of California, School of Law and obtained two legal masters degrees from Golden Gate University, School of Law: Master of the Laws of Taxation, with honors, and Master of the Laws of Intellectual Property. Selwyn is admitted to practice in California and also holds a California Real Estate Brokers License. Since 2010, Selwyn has produced and hosts the weekly talk show, SELWYN’S LAW, airing Saturday mornings on the Christian Radio Stations KDIA and KDYA. The show provides its listeners with practical, down-to-earth and legal-jargon-free information about finance, taxation, real estate, trusts and estates, and bankruptcy law and the public policy basis for each area of the law.

In 2011, the Alameda County Bar Association’s Volunteer Legal Services Corporation awarded Selwyn the prestigious Volunteer of the Year Award for her pro bono bankruptcy and tax work for low-income residence in Alameda County. On April 1, 2013, Selwyn obtained the designation of Certified Specialist in Bankruptcy Law from The State Bar of California Board of Legal Specialization.

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