October 23, 2015
Authored by: Kathy Sherby
In a recent bankruptcy case, Richard Lewiston unsuccessfully attempted to shelter his assets in the Lois and Richard Lewiston Living Trust (the “Trust”) from inclusion in his bankruptcy estate based on the Trust’s spendthrift provision. Here, the bankruptcy court looked to Michigan state law in applying the provisions of the Bankruptcy Code and concluded the Trust property was part of Lewiston’s bankruptcy estate.
Facts about the Trust:
- Richard and his wife created the Trust in 1986.
- Richard and Lois were the only beneficiaries of the Trust for as long as either of them were alive.
- Richard and Lois served as the Trustees, and either Richard or Lois were designated to act as the Managing Trustee with the power to manage the Trust assets.
- The Trust contained a Spendthrift Provision protecting all beneficiaries from claims by creditors.
- The Trust also contained a provision allowing it to be “amended, modified or revoked, in whole or in part, but only by the joint action and consent of Richard and Lois.”
- In 2008, they amended the Trust to provide that the Trust would become irrevocable once one of them died.
In 2012, when Richard filed bankruptcy, he disclosed the Trust for “notice purposes only” and claimed that it was excluded from his bankruptcy estate under Section 541 of the Bankruptcy Code, which provides an exclusion for trust property subject to a transfer restriction “enforceable under applicable nonbankruptcy law.”
The bankruptcy trustee took exception to this claimed exclusion and filed a complaint in the bankruptcy case against both Richard and Lois, taking the following positions:
- The spendthrift provision of the Trust is not enforceable under Michigan law as to Richard;
- Self-settled spendthrift trusts are against Michigan’s public policy; and
- The Trust property was includible in Richard’s bankruptcy estate.
In essence, the Court found Richard had complete control over the Trust property. Richard’s testimony established the following bad facts:
- He consistently deposited distributions from Trust assets into his personal bank account; and
- He dealt with Trust property without disclosing the Trust, notwithstanding the Trust provision that the actions of both Lois and Richard were required to remove property from the Trust.
Nevertheless, Richard claimed that the spendthrift provision was enforceable because the Trust could not be revoked without Lois’s consent, making it irrevocable as to him. Lois filed a response claiming that she had contributed her own property over time to the Trust in the total amount of about $1.5 million, but didn’t submit her signed declaration to that effect until the day before the hearing.
The Court was tasked with determining whether there was a restriction on the transfer of Richard’s beneficial interest in the Trust that was enforceable under Michigan nonbankruptcy law. Under controlling common law, a self-settled spendthrift trust that attempts to place the settlor’s own assets beyond the reach of his/her creditors while retaining the beneficial interest in such assets violates Michigan public policy.
Richard, however, claimed that the Trust was irrevocable because he could not revoke the Trust without Lois’ consent, and that the Michigan Trust Code (MTC), enacted in 2010, overruled this common law so that Michigan now permits irrevocable self-settled spendthrift trusts. Specifically, Richard relied on a section of the MTC which states that during the life of a settlor, while a revocable trust is subject to the claims of the settlor’s creditors even if the trust contains a spendthrift provision, if a trust is irrevocable, the settlor’s creditors can only reach the “maximum amount that can be distributed to or for the settlor’s benefit.” Further, if the trust has more than one settlor, the creditors are limited to “settlor’s interest in the portion of the trust attributable to that settlor’s contributions.”
The Court noted that the MTC did not expressly authorize self-settled spendthrift trusts or specifically state whether it “abrogates or continues to recognize the public policy exception against self-settled trusts under Fornell, Johannes and Hertsberg, all of which predate the MTC.” The Court held that the MTC could not be said to abrogate Michigan common law as to Michigan’s public policy against self-settled spendthrift trusts, and this common law prohibition against self-settled trusts retains its vitality. Accordingly, Michigan law did not validate the Trust’s spendthrift provision as to Richard, and the Trust was not an excluded asset under the Bankruptcy Code.
Lastly, the Court rejected Lois’s argument, that Fornell did not apply at least to the funds she contributed to the Trust because she was also a settlor of the Trust. Lois had not submitted her signed declaration concerning the assets she had deposited into the Trust until just one day before the scheduled hearing, which the Court said was not timely and should therefore be ignored as not properly before the Court. The Court also stated that Lois had cited no authority to support her argument that her contributions to the Trust, which did not name her as settlor in the trust instrument, would make her a settlor of the Trust as to those contributions or limit the access of Richard’s creditors to those contributions. All of the assets of the Trust were therefore included in Richard’s bankruptcy estate.
*Thanks to Alex Fersa for drafting assistance.