A recent, and controversial, bankruptcy case permitted a creditor to take assets in a trust despite the spendthrift clause. This decision has caused quite a stir in the estate planning/asset protection community. Whether such a reaction is justified depends on how one interprets the decision.

In the case, a mother established an inter vivos trust which provided that, upon her death, that the trust would terminate upon the settlement of her estate and be distributed outright to her children. The trust provided that if creditors of a beneficiary tried to seize assets still held by the trust before the estate was settled, then the outright interest of that beneficiary would be converted to a spendthrift trust for the benefit of the debtor/beneficiary.   In Re Castellano, 514 BR 551 (2014).

Sometime after the mother’s death but before the estate was distributed, one daughter’s attorney instructed the trustee that the daughter was insolvent, so that a new account would be set up for the daughter’s benefit with spendthrift provisions. Under these circumstances, the Bankruptcy Court held that the creditor could have access to those funds.

One interpretation of the case is fairly benign. The Bankruptcy Court held that the debtor made an indirect transfer of her interest to a self-settled trust by “recruiting” the spendthrift trustee to create such a trust. The key to this interpretation is a finding that the daughter’s share of the estate vested at her mother’s death. Thus it fell afoul of the self-settled trust rules that preclude a debtor from establishing a trust that is immune from his or her creditors. The only exception to the self-settled trust rules are domestic asset protection trusts that are permitted in some states, provided that funding is not a fraudulent conveyance.

A less benign interpretation flows from dicta, discussing the identity of the trustee and the wholly discretionary nature of the trust. These facts led the court to conclude that the debtor/beneficiary was the one really in charge of the trust. “The Court cannot ignore the family relationship between the Debtor and the Spendthrift Trustee, as well as the total absence of any Court supervision or control over the Spendthrift Trustee’s decisions concerning disposition of assets of the Spendthrift Trust.” Id. at 10. The Bankruptcy Court used the family relationship as a secondary proof of its conclusion that the debtor was controlling the trust. As long as that conclusion is within the context of a self-settled trust, and not as a general proposition, the case is not remarkable. Otherwise, it is very troubling and, undoubtedly, incorrect as a matter of law.

The Castellano court hung much of its factual conclusion on the debtor instructing the trustee not to distribute the assets to her. The court determined that the debtor, not the trustee, actually controlled the disposition of the assets. The Castellano result should be easily cured by drafting. First, trusts should continue at the settlor’s death for the beneficiaries with spendthrift provisions (or discretionary trust provisions), so that the vesting argument is off the table. If one wants to make an outright distribution to a beneficiary, while hedging the bet on the insolvency issue, the trust could provide that principal is to be distributed outright to a beneficiary only upon certain conditions (one condition being solvency). In other words, have the vesting conditioned on each beneficiary attesting that he is solvent rather than the Castellano trust where, in effect, the beneficiary submitted proof of insolvency to reverse automatic vesting.