A recent article explores the efficacy of offshore trusts in protecting the assets of debtors, Go Directly To Jail, Do Not Collect $200! Do Asset Protection Trusts Carry A Mandatory “Go To Jail” Card? Should They? 37 Probate & Property Magazine 05 (Sept./Oct., 2023). The premise of the article is an old one, at least within the relatively new body of law that has grown around asset protection planning: Debtors may be parsed into good debtors and bad debtors, and while offshore trusts should not be expected to work with bad debtors, offshore trusts should work as expected with good debtors.
To fully understand this issue, some considerable background is required. First, one must understand the differences between foreign asset protection trusts (FAPTs or offshore trusts) and domestic asset protection trusts (DAPTs).
Both types of trusts are self-settled trusts, which mean that the trusts are created by a settlor for the benefit of the settlor. Traditionally, in Anglo-American law, if a self-settled trust has a spendthrift provision which purports to protect the trust’s asset from creditors of a beneficiary, that provision will be ineffective as to a self-settled trust. This doesn’t mean that such a trust is “illegal” per se, but only that the spendthrift provision will be inoperable. There is a separate body of law in some jurisdictions to the effect that a trust in defraud of creditors is void ab initio, but that is not necessary to our discussion here.
A domestic asset protection trust is a creation of state law, meaning that a state’s legislature has enacted legislation that enables the spendthrift provision of a self-settled trust to be effective. Such a trust, being a domestic trust and usually having its assets held domestically, depends wholly on the U.S. courts respecting the state law that works to protect the assets of the trust. In other words, for a DAPT to work at all, any state or federal court that is confronted with a DAPT must respect the laws of the state that created the trust. The problem is that while about half the states have adopted DAPT legislation, the other half have not, and their courts in the states that have not adopted DAPT legislation have routinely chosen to apply their own law (and not that of the DAPT state) to determine whether the spendthrift protection will be available. Further, Congress in 2005 created a 10-year limitations period for fraudulent transfer challenges to transfers made to such trusts. A more detailed discussion of when DAPTs work and when they do not is the subject of my article Easy Chart Regarding Effectiveness Of Asset Protection Trusts (Nov. 15, 2011), but basically it comes down to this: DAPTs will work so long as the settlor and all assets are in a DAPT state and the settlor can stay out of bankruptcy, and DAPTs will probably not work otherwise. In any event, what you should take away from all this is that DAPTs will be effective if and only if the involved domestic courts rule that they are effective in a particular situation.
With one critical exception, which will be discussed in-depth below, foreign asset protection trusts are designed so that it simply doesn’t whether any U.S. court ― state or federal ― respects the trust or not. Because the trustee and all assets are outside the United States, the trustee can literally thumb its nose at any ruling by any U.S. court. An order from a U.S. court is not worth the paper that it is written on in the offshore jurisdiction. Offshore trustee to U.S. District Judge: “Go stuff yourself.” The laws of the offshore jurisdiction will not recognize a U.S. judgment and are otherwise heavily pro-debtor; thus, any attempt by creditors to get at the assets of an offshore trust in the courts of the offshore jurisdiction will be futile in all but the most unusual circumstances. In practice, most creditors don’t even bother to try to collect assets in the offshore jurisdictions because the odds are so low that it does not even justify the attempt. FAPTs are thus a brute force solution for which U.S. law is irrelevant.
In this regard, FAPTs are close to the perfect asset protection vehicle. So perfect in fact, that many folks who create FAPTs will stop right here in their explanation of the structure and hand their putative clients an engagement letter. But there is a fly in the offshore trust ointment that at least the asset protection planners having at least a modicum of professional ethics will go on to discuss: Although the assets held in a FAPT are offshore and completely protected, the settlor may still be in the United States and subject to the rulings of the domestic courts.
Before we discuss the fly in the ointment, it is important to understand what normally happens when a debtor in the U.S. has assets outside of the country (foreign assets), and to understand that we need to first recap how assets are collected between states.
Let’s say that a judgment debtor in California has a bank account in Virginia. There are two common ways that a creditor can get money in the bank account in Virginia. First, the creditor can domesticate the judgment in Virginia and then have the local sheriff in Virginia garnish the bank for the moneys. This takes time to get the judgment domesticated (at least 30 days for that alone), and then however long it takes for the sheriff to receive the right paperwork and head over to the bank to serve the garnishment. In the meantime, the cash could be cleared out by the debtor unless the creditor takes the additional step of having the Virginia courts freeze the money in the meantime ― which can be costly since then local Virginia counsel would be required.
The second way is much faster: The creditor can ask the California court to issue a turnover order that requires the debtor to cash out the Virginia account and transfer the moneys to the local California sheriff’s office. While the turnover over has utterly no legal effect in Virginia, it is binding up on the debtor in California such that if the debtor does not comply, the debtor can be held in contempt and sent to the county jail until the moneys arrive.
Enforcing a judgment against foreign assets held in another country works about the same way, except that the turnover order is by far the preferred method. Let’s say that a Texas debtor has an account in Dublin. The creditor could domesticate the Texas judgment in Ireland, but there is no Full Faith & Credit under the U.S. Constitution between Texas and Ireland, so domesticating the judgment will generally take much longer. Similarly, a the creditor could attempt to get a Mareva injunction in Dublin to freeze the account in the meantime, but that will also be quite costly.
Instead, the creditor could ask the local Texas court to enter a repatriation order (basically, the international version of a turnover order) that requires the debtor to cash out the Dublin account and return the moneys to Texas and turn them over to the local sheriff. As with domestic turnover orders, the repatriation order has absolutely no legal effect in Ireland but it is binding upon the debtor in Texas. So, the debtor can either return the money to Texas or go sit in the county jail.
If you are curious about how long a debtor can be held in jail for contempt for refusing to repatriate foreign assets, the record belongs to H. Beatty Chadwick who sat in jail for 14 years after refusing to return assets in a Swiss bank account to the U.S. so as to pay money to his ex-wife as part of a bitter divorce action.
The smallish jurisdictions that have FAPT legislation are known as “debtor havens” because their laws are very anti-creditor. These jurisdictions will not automatically recognize a foreign judgment, either through treaty or through friendly judicial recognition known as comity, which basically means that courts respect the judgments and orders of other courts out of a desire that their own be similarly respected. Thus, a creditor seeking to enforce a judgment in an offshore haven such as the Cayman Islands, Bahamas, Cook Islands, Isle of Man, etc., would have to file a new lawsuit there and try the case ab initio as if there never was a judgment anywhere. Not only will this be very costly, but these jurisdictions sometimes require that a plaintiff post a deposit in case they lose so as to pay the defendant’s legal fees. Moreover, because these jurisdictions have as one of their biggest financial sectors to help debtors dodge judgments (they usually don’t have much else going on), the courts will start out tilted against a creditor. So, for all of these reasons creditors cannot use the normal first option of simply registering a judgment there, nor because of the costs do they attempt to re-try and obtain a new judgment in any of these debtor havens.
All this means that the only practical remedy available to a U.S. creditor for the assets held in an offshore jurisdiction is a repatriation order. That now finally brings us back to the fly in the ointment of FAPTs, which is that the assets may be offshore, but the person of the debtor may still be within the jurisdiction of the domestic courts and thus be subject to being held in contempt.
I used the term “may” in the last sentence, because it should not be presumed that the settlor may stay in the U.S. as sometimes financially-distressed settlors will simply leave and go abroad. This tends to happen with truly international persons, meaning those who have families or other interests outside the United States or can live in another country and be cool with it. For these folks, an FAPT is indeed the perfect asset protection plan because it does not come with the downside I will describe below. So if somebody says “FAPTs never work” they are wrong. If nothing else, FAPTs absolutely work for this class of settlors in all but the rarest of cases and most determined of creditors (and they may even work then).
However, leaving the country usually not an option for persons who have all their family living in the U.S. or who are in a business such as a professional practice where trying to re-establish oneself outside the U.S. would be a nightmare. The folks are stuck within the jurisdiction of the domestic court, and thus are susceptible to the contempt remedy. And that’s exactly what happens to them.
FAPTs are specifically designed against this contingency. In fact, FAPTs exist primarily because of this contingency. If a debtor could not be held in contempt for not complying with a repatriation order, then the debtor could simply keep funds overseas in a debtor haven and there would be nothing that a creditor could practically do about it. But such a debtor can be held in contempt for not complying with a repatriation order, and FAPTs are designed to deal with this one contingency.
A charade is defined as an absurd performance meant to create a respectable appearance. Keep that in mind for what follows.
FAPTs are drafted so that when a debtor who has an offshore trust receives a repatriation order, the debtor will make a request to the trust requesting that all the trust assets be returned to the debtor so that the debtor can comply with the repatriation order. The trustee will then respond back to the debtor that because the debtor is obviously under duress because of the repatriation order, the trustee must refuse because of the duress clause in the FAPT trust document which mandates that the trustee must refuse to comply with all requests of the debtor if the debtor is under, well, under duress because of the repatriation order. The debtor then goes back to the domestic court and advises that compliance with the repatriation order is impossible because the trustee has refused to return the assets. This is all a charade that was planned before the FAPT trust document was even signed and was anticipated to occur by all involved in the event that the debtor received a repatriation order.
We now thus come to the impossibility defense, which is based on a general rule of contempt law to the effect that a person cannot be held in contempt for refusing to do the impossible. When the debtor does not comply with the repatriation order, the creditor will next move to hold the debtor in contempt for violating the order. The court will then have an evidentiary hearing (sort of a mini-trial) to determine whether the debtor will be held in contempt. In defense, the debtor will assert that he cannot be held in contempt for violating the repatriation order since he attempted to comply with the repatriation but the offshore trustee of the FAPT has refused to allow him to comply. Thus, the debtor will claim, his compliance is impossible and he cannot be held in contempt. The early theory espoused by true father of asset protection, the late Denver lawyer Barry Engel who was instrumental in the passage of the first true FAPT laws anywhere, being in the Cook Islands in his case, was that everything ended right there. The U.S. court couldn’t hold the debtor in contempt, and the U.S. court had no power to force the offshore trustee to do anything. Case closed. It’s Miller time.
But Barry Engel was wrong.
Scarcely a decade after Barry Engel brought forth the Cook Islands international trust legislation that was the impetus for the entire modern asset protection sector, two court decisions came out in 1998 and 1999 respectively that extinguished the idea that an offshore trust settlor and debtor would invariably avoid jail by asserting the impossibility defense, being the Lawrence case, Goldberg v. Lawrence (In re Lawrence), 227 B.R. 907 (Bk.S.D.Fla., 1998), and the Anderson case, FTC v. Affordable Media, LLC, 179 F.3d 1228 (9th Cir., 1999). Lawrence ended up spending several years in jail; the Andersons (husband and wife) spent six months. But even while they were still in jail, the calculus of using FAPTs for asset protection changed from if an FAPT settlor/debtor could be incarcerated (the answer to that was now known to be “yes”) to whether the odds were such that it was worth the risk.
After the Lawrence and Anderson decisions, the asset protection planning sector divided into basically three groups. The first and ultimately largest group gravitated towards the shiny new object of Domestic Asset Protection Trusts (DAPTs, or self-settled trusts formed in Nevada, Alaska, Delaware, etc.), even though those were untested — and, ultimately, they would routinely fail too. The second group, including Barry Engel himself, started to gravitate away from standard offshore trusts to more exotic structures such as foreign foundations, e.g., Liechtenstein or Panama foundations. The third group were those who simply kept the faith in FAPTs on the basis that so few were challenged anyway, and those that were challenged usually ended in a settlement before the creditor could get around to a repatriation order and contempt proceedings. In more recent years, with DAPTs failing to live up to their expectations, there has been a slight migration of the first group back towards offshore planning with FAPTs.
For what it is worth, I do not consider FAPTs to have failed so much as the promises made about their benefits had been seriously overstated from the outset. As discussed, an FAPT could still be a very useful planning tool for an international person willing to live elsewhere should problems arise in the United States.
But why did the FAPT debtors go to jail in the Lawrence and Anderson cases? A cursory explanation is given below, but the reader is strongly suggested to actually read those opinions in the links above as they will go into much greater technical depth than is presented here.
Recall that the impossibility defense is based on a general rule of contempt law. Being a general rule, that means we next have to look at the rule for general rules, known itself as The General Rule. As law school students usually learn within the first couple of weeks of law school, The General Rules posits that general rules are generally inapplicable. The general rule of the impossibility defense is not immune from the General Rule; if anything, it is an excellent example of The General Rule’s power and breadth.
A court’s analysis of the impossibility defense does not end, as Barry Engel had predicted, with the debtor telling the court that compliance with the repatriation order is impossible. To the contrary, that merely sets up a subsequent analysis that features three key elements as described below.
First, it must be demonstrated that the act required of the debtor is reasonably impossible considering every action that might be taken, and not just those that were taken. This is literally “proving a negative” for those who don’t believe that the courts would ever require such a thing, but in this circumstance they do.
Second, the burden of proof is on the debtor to prove the impossibility. That means the debtor must prove the negative of any reasonable way to comply with the repatriation order. If the debtor fails in this proof, the debtor will be held in contempt. Which of course means that it is not required of the creditor to prove that the debtor could have done something to comply, though of course a creditor may decide to do that if the evidence supports it.
Third, and most importantly, a self-created impossibility is not a defense to contempt.
Even if a debtor can prove the impossibility, debtors attempting to assert the impossibility defense have almost always failed on this last element. When the debtor created the FAPT in the first place, the debtor agreed to the duress clause which caused the offshore trustee to fail to comply with the repatriation order for which the duress clause was designed to address.
The charade that the debtor and offshore trustee play out in making the pre-planned request and pre-planned refusal does not overcome this element, and at any rate while that charade might or might not have been of interest to the first few courts who watched it, after a while the courts caught on that it was also just a charade, so much legal Kabuki Theater. The only thing that matters becomes whether the debtor has proved an impossibility and, if so, whether the impossibility was self-created ― which of course it is in the case of FAPTs because that is exactly how they are designed.
This is not to say that the impossibility defense will never work for a debtor with an FAPT facing a repatriation order. It can work, and at least in one case (Bellinger) it did work albeit more because of questionable lawyering by the creditor’s attorney involved in the case than anything. But a win is a win is a win, even if it is just one win out of numerous other bad outcomes for debtors with FAPTs.
Which all brings me back to the article which is the impetus for this writing. The question posed by that article is whether FAPTs are invariably doomed to fail. I agree with the conclusion of the article that FAPTs are not invariably doomed to fail, as a creditor as a creditor will need to connect all the dots in the correct order to get to the court holding the debtor in contempt. There may also be certain circumstances that militate for or against holding the debtor in contempt in particular cases. So, I think the referenced article has reached the right answer, but I also think that it has asked the wrong question.
The correct inquiry, to me at least, is not whether an FAPT can work, but whether the odds are high enough of a particular debtor being able to successfully assert the impossibility defense such that the debtor would risk a hearing to that effect. Otherwise stated, would you run the risk of going to jail if the odds were 50/50? How about if the odds were less than 1 in 20 which is about how the reported court opinions have come out? That a debtor with an FAPT might theoretically be able to avoid jail based on the impossibility defense seems to be small consolation when the probability of the impossibility defense failing has actually proven to be very high.
This is a different issue than whether FAPTs should be used for particular clients in particular circumstances. Remember that for international persons willing to leave the domestic jurisdiction and live abroad, none of this contempt stuff matters because the court cannot enforce its contempt order against them. Moreover, for a creditor, FAPTs are well-known to be costly and time-consuming to pursue, and similarly costly for a debtor who likewise better hire quality counsel, so a good many of these cases are settled on some basis or another (I will let others argue about who “won” the settlements). It seems to me at least that most of the FAPTs cases that have gone so far that the debtor was sent to jail were cases in which the debtor could probably have settled beforehand, as indicated by the fact that usually after spending some time wearing the orange jumpsuits they were able to work out settlements so that they could finally go home. But representing debtors as well as creditors, I know all too well that debtors often make bad decisions not to settle out of everything from sheer stubbornness to reading misinformation on the internet and believing it to be gospel, and that is certainly not peculiar to settlement decisions where the debtor has an FAPT.
We now come to the old but vigorously-pressed argument that has percolated within the FAPT planning community since the Lawrence and Anderson decisions were issued. The argument is that there are good debtors and bad debtors. The bad debtors are folks like Lawrence and the Andersons who have engaged in bad conduct, and of course the court is not going to have trouble finding folks like that in contempt. But what if you have somebody positioned quite differently, such as the kind and gentle local doctor who has practiced for many decades but doesn’t want to see the financial nest-egg took her so long to build up be wiped out by one malpractice lawsuit? Where there is a good debtor, the argument goes, the courts should not be expected to hold such a person in contempt much less send them to jail.
I’ve heard this argument for years ― check that, two decades now ― and it still doesn’t hold water with me. This is a good opportunity to explain why I do not believe that it is reasonable to believe that the courts are likely to parse good debtors from bad debtors in all but the rarest of cases, and maybe not even then.
For purposes of this discussion, we will presume that a person had no existing creditors at the time that they settled (created) their FAPT, and even after the transfers to their FAPT they were clearly solvent by any reasonable measure. We will also presume that they at all times correctly reported and paid all income taxes relating to the FAPT, and that whatever liability they suffered later was not the result of some crime, securities fraud, Ponzi scheme, or other serious offense. In other words, dream up the best scenario that you can imagine for an FAPT to work (other than the person never gets sued in the first place) and we’ll run with that scenario.
I still don’t think the courts will parse “good debtors” from “bad debtors” even in that rosy scenario.
First, there is no technical legal reason why one debtor attempting to assert the impossibility defense should be treated any differently than any other debtor attempting to assert that same defense. A court will simply look at whether the impossibility was self-created, and in the case of an FAPT it was. While the facts leading up to the judgment might make for interesting background reading, basically nothing that occurred prior to the judgment (meaning what the debtor did or didn’t do leading up to the judgment) or, really, even before the repatriation order was entered has any effect on this analysis conducted by the Court. Note also that the state legislatures have also determined what debtors may protect, known as exempt assets, and what they may not being everything else, and the courts have no powers to expand these exemptions.
Second, in the eyes of most judges, all debtors are bad debtors … or at least will become bad debtors as the post-judgment enforcement proceedings drag on. Good people pay their judgments, bad people do not. But even if a particular judge is initially ambivalent about a particular debtor, what happens is that as the judge spends more and more of its time dealing with that debtor, the judge will eventually start to take the attitude that the court’s limited resources are being wasted only because the debtor doesn’t want to pay the judgment, and thus the debtor winds up being bad debtor in the eyes of the court. Good luck asserting the impossibility defense once that has happened. Creditor rights attorney understand this phenomena only too well, and so usually not even seek the repatriation order until the particular judge has finally turned on the debtor.
Third, in the eyes of some (but not all) judges, the mere fact that a debtor has engaged in asset protection planning makes them a bad debtor per se. For instance, a U.S. District Judge wrote just last month that “[a]sset protection is, however, nothing more than a euphemism for evasion. For decades, Americans have used Cook Islands trusts trying to avoid the reach of American courts.” Galloway v. Martorello, 2023 WL 5229231 at *11 (E.D.Va., Aug. 14, 2023). The Galloway opinion did not deal with the impossibility defense as the U.S. District Judge was only considering the right of creditors to obtain discovery about the trust in contravention of Cook Islands’ law, which ended up being ignored. But good luck prevailing upon the impossibility defense before that judge. Admittedly, not all judges hold such a dim view of asset protection planning; some judges are blissfully ambivalent about the subject. But that’s the thing: Debtors do not get to choose their judges, thus cannot know in advance whether they will get a judge who from the very outset has decided that the debtor is a bad debtor (and, no, that belief, even if a debtor could prove it in advance of a ruling, would not be sufficient to disqualify the judge).
Fourth, asset protection planners have no all-seeing OUIJA board that lets them know in advance what their might be sued for. Let’s take the stereotypical example given of a good debtor: The kindly doctor trying to protect her life savings against a medical malpractice judgment. But suppose the judgment doesn’t arise out of a medical malpractice judgment at all, but instead the kindly doctor was driving a little tipsy one night and crashed into a bus. Think a judge will have much sympathy for that?
But even the scenario where the kindly doctor suffers a malpractice judgment doesn’t make much sense. Consider that the malpractice judgment would have to be in excess of the doctor’s professional negligence insurance (or else it doesn’t matter because the insurance will pay up). For such a so-called excess verdict (a verdict in excess of coverage) to occur, whatever the doctor did was probably pretty egregious, and in that circumstance good luck getting much sympathy from the court. Moreover, if the court would have demonstrated any sympathy at all, it would be in cutting down the amount of the judgment (known as remittitur) and not later during the judgment enforcement stage.
Finally, when this argument started to be floated right after the Lawrence and Anderson decisions, I predicted that good debtors would be unicorns: Much theorized about, but no actual real world sightings. I don’t know how many opinions that we’ve had now where the impossibility defense was asserted in connection with an FAPT (I lost count somewhere around 20), but in no opinion so far has there been anything like an indication by the courts that they were willing to cut a debtor a break because they were a good debtor as opposed to a bad debtor. So my question now is this: Why haven’t all these good debtors actually materialized to win on the impossibility defense?
The answer to this question is obvious to a litigator. If a good person simply made an honest mistake, they are probably going to either win at trial or the amount of the judgment will be within the limits of their insurance coverage. That person is not going to be a debtor, and there are not going to be post-judgment enforcement proceedings. However, once somebody loses a judgment, then it is the jury who has decided that they are on the wrong side of the law, and if they don’t pay their judgment then the courts aren’t going to have much sympathy for them.
Asset protection planning has demonstrated an amazing degree of creativity over the years. Creativity is good and I have no problem with it. In the law, however, all things are eventually actually tested in that legal laboratory known as the crucible of the courtroom. While theorizing is fun, the test of a theory’s validity must ultimately come in court and not by merely hoping that someday it might work. So far, this theory keeps coming up negative.
Having said all that, I again admit that a rare debtor in a rare case (I think Bellinger is the only such case so far, at least that I’ve heard of) might be able to convince a particular judge to exercise the court’s discretion not to hold the debtor in contempt for not repatriating the assets from the FAPT. But that misses the point: The probability of any particular debtor winning such relief from the court is very low. Who would engage in a particular planning strategy if for that planning to ultimately be successful would run the risk where the odds are north of 19 in 20 of going to jail? Who would even do it if the odds were as good as 50/50?
This is where I have a problem with most (but not all) of the folks who sell FAPTs, which is that they tell their clients only half the story, being that the clients will assert that it is impossible for them to repatriate their assets from their FAPT, without telling them the more important other half of the story, which is that the impossibility defense is almost sure to fail. The better FAPT planners will at least discuss this outcome with their clients, with the idea being to not get to the point of a repatriation order but instead try to settle the matter beforehand (better to give up 60% and retain 40% than to lose 100%).
In reality, very few people who set up FAPTs actually become judgment debtors (the same is true with DAPTs). Without knowing, I would suggest that for every debtor with any kind of asset protection trust, there are probably at least a thousand who will never see their trust structure seriously challenged by a creditor. It is very much like fire insurance where for every 10,000 homeowners who pay premiums every year, maybe one or two will actually have a fire. Your own odds of actually having a fire are almost nonexistent, but would you really go without fire insurance? Whether an FAPT will ultimately work or not if somebody gets as far as being faced with a judgment and a repatriation order, there is little doubt that they work well as sort of a legal placebo that let’s some people sleep better at night. To a significant extent, much asset protection planning is of this nature, which is why some hucksters can sell all sorts of utter junk planning having no chance of working as “asset protection” and get away with it, since the odds of it ever being tested are minimal.
It must be pointed out that there are some people who know or suspect that they will someday become judgment debtors, or may even have a judgment already, and try to set up an FAPT (or something else) to try to avoid their judgment. As I have stated many times, this sort of planning is not asset protection planning at all but simply fraud on creditors. These are bad debtors right out of the gate, and there is utterly no possibility whatsoever that the impossibility defense will work for them, and it hasn’t in any case.
Very importantly, this is not to suggest that that all asset protection planners who use FAPTs are wrong or misguided or anything like that. There are no perfect asset protection solutions, only a choice of imperfect solutions that can have different outcomes in different situations. An offshore trust will, if nothing else, usually draw a palatable settlement offer because a creditor will not want to put in the time and expense to go all the way down the path to the repatriation order and contempt remedy. It’s only if the case doesn’t settle and a debtor gets to the point of the repatriation order that things can then start to get ugly.
Anyway, these have been my thoughts on the subject if they weren’t already known, or folks have simply forgotten them due to the passage of time, to which I would not be at all surprised. Please feel free to disagree; I’ve never claimed to have the ultimate right answer, but have only asked that folks do their own research and treat the subject as they would any other technical subject without relying exclusively upon the opinions of others (including myself).
Read the full article here
