By Stephen Speiser, Esq.
We need to have a serious conversation about domestic asset protection trusts (DAPTs). By our last count, 20 states now have DAPT laws: Alabama, Alaska, Connecticut, Delaware, Hawaii, Indiana, Michigan, Mississippi, Missouri, Nevada, New Hampshire, Ohio, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah, Virginia, West Virginia, and Wyoming. Yet, the rush to implement DAPT legislation – motivated by state bar associations and the banking industry always looking for more revenue – is likely to leave many DAPT clients feeling burned and misled for one simple reason: DAPTs don’t work for asset protection.
History of the DAPT
The inspiration for state DAPT laws comes from the success of foreign asset protection trust (FAPT) laws and, in particular, the Cook Islands International Trusts Act which was the first of its kind. The 1989 amendments to that law created the first-ever statutory self-settled spendthrift trust that allows the settlor to be both a beneficiary of their own trust and fully protected from the claims of creditors. Early success in the Cook Islands led to a proliferation of FAPT laws in a host of other exotic offshore jurisdictions, including Belize, Nevis, and Mauritius.
Over the years, the success of the FAPT has attracted the interest of bad actors seeking to shield assets that the law was never meant to shield i.e., proceeds from criminal conduct or blatant fraudulent transfers. Creditors have also evolved in their response to FAPTs, utilizing what few tools are available in the U.S. court system to put pressure on settlors who retain too much control over their FAPTs or who abuse the court process to conceal assets held offshore.
One critic of FAPTs asserts that their use has “resulted in 30 or so published opinions involving the settlor being sent to jail.” Yet, a careful analysis of all these cases shows that there has not been one single instance where a settlor has gone to jail or had the trust overturned where an FAPT was properly established and funded prior to litigation. In fact, the experience of our firm – and the trust companies that have worked in this space continually since 1989 – demonstrates that the FAPT remains the single most powerful asset protection planning device available.
Nevertheless, the explosion of interest in FAPTs following the 1989 amendment to the Cook Islands International Trusts Act likely inspired all the copycat legislation in the United States. In 1997 Alaska became the first state to enact components of the Cook Islands APT legislation into its domestic trust law. This was shortly followed by Delaware, and almost thirty years later we have DAPT legislation in just under half the states of the union.
Do DAPTs Work?
We are reminded of the old adage, “If it ain’t broke, don’t fix it.” Yet this is exactly what state legislatures have done with their DAPT legislation: they have reinvented the wheel, taking well-established statutes and doctrine from the FAPT arena and cast a domestic veneer over the arrangement… but did any of this legislation actually work?
In short, no. More to the point, the results of published cases involving DAPTs are terrifyingly awful and raise the specter of legal malpractice for the lawyers who recommended their use. While we work with existing foreign trust companies to provide FAPT planning services for our clients, we do not have a bias favoring of FAPTs if we can get the same or a better result from a DAPT. It’s exceedingly rare, but there are a handful of instances where this could happen. However, the sad truth is that DAPT legislation does not work as intended, can never work as intended, and is hopelessly misleading to those who use DAPTs in the belief that they are achieving anything of material value over a traditional domestic trust.
Why do DAPTs fail? We can generally categorize the critical flaws in DAPT legislation as follows:
- Constitutional Infirmity: The single most significant flaw of DAPT legislation is that such laws are powerless against a foreign (out-of-state) judgment. Under the U.S. Constitution, Article IV, i.e., the “Full Faith and Credit” clause, every DAPT state is legally bound to recognize and enforce a judgment issued against a DAPT trustee by another state. Courts in Alaska and Delaware have already ruled that the U.S. Constitution mandates that their DAPT laws yield to out-of-state judgments as well as ancillary proceedings.
- Use of DAPT Law by Non-Residents: If you are not a resident of the DAPT state in which your trust is formed, you may learn the hard way that an out-of-state DAPT will not shield your assets. For example, in a recently reported case, a resident of the State of Washington (which does not have a DAPT law) set up a DAPT in Alaska to shield his assets. The Alaska Supreme Court held that Alaska DAPT law would not prevent an out-of-state creditor from seizing the assets held by the Alaska DAPT.
- In-State Treatment of Out-of-State DAPT: Even if a DAPT state permits a non-resident to establish a DAPT within that state, their home state may have something to say about it. A court in California ruled that establishing and funding an out-of-state DAPT is evidence of a “bad intent” and ruled that it was a fraudulent transfer (i.e., a voidable transaction). In that case, the creditor was awarded a judgment against a Nevada DAPT trustee. That judgment, as previously noted, would then be enforceable in a Nevada court against the Nevada trustee of the Nevada DAPT that was settled by the California resident. A court in Illinois likewise invalidated an out-of-state DAPT settled by one of its residents. Expect most non-DAPT states to rule the same way on public policy grounds.
- Federal Law: Some areas of U.S. federal law, such as bankruptcy law, conflict with DAPT legislation. Under the U.S. Constitution, state laws must yield to federal law in the event of such conflict. This means that a creditor can use of federal bankruptcy law to claw back transfers into a DAPT formed by a resident domiciled in that same state.
- Case Law: The caselaw we have on DAPTs as an asset protection vehicle has shown them to be a colossal failure… Not close, not debatable, but a complete and total failure. This includes cases from well-known DAPT jurisdictions such as Alaska and Delaware and from other states that have more recently adopted DAPT legislation such as Utah. In fact, there is not a single published case anywhere in the United States proving the efficacy of a DAPT in any single instance. One lawyer who was instrumental in drafting Nevada’s DAPT law argues that the adverse cases to date are not fair to DAPTs and instead represent “bankruptcy and fraudulent transfer cases, not choice-of-law cases.” However, this belies the reality of asset protection trust legislation. It is always going to be the case that creditors will rely on fraudulent transfer (aka voidable transaction) rules or bankruptcy law to attack an asset protection trust, whether domestic or foreign. The problem is that DAPTs are fundamentally vulnerable to both fraudulent transfer and bankruptcy law, whereas FAPTs have proven to be immune to such challenges when legitimately funded in advance of litigation.
Does this mean that clients should avoid using DAPTs altogether? Not necessarily, but it does mean that any competent asset protection plan should always strive to rely on the FAPT as the ultimate firewall to shield assets. Given the additional cost to going offshore, we are not going to recommend an FAPT to each and every client. The cost of the asset protection plan has to be reasonable in relation to the assets being preserved, and some assets simply cannot be held in a FAPT (e.g., domestic real estate). Nevertheless, instead of recommending a DAPT in such situations, most clients are better served utilizing structures with proven effectiveness, such as domestic asset protection LLCs (AP-LLCs) and domestic asset protection limited partnerships (AP-LPs).
In certain limited instances, our firm may recommend the use of a DAPT, particularly if there is a need for a domestic trust. For example, if a client seeks to establish a domestic dynasty trust, we will recommend that the dynasty trust be formed and qualified as a DAPT in a state with a combination of strong DAPT and dynasty trust legislation, such as South Dakota or Wyoming – but never for the sole purpose of asset protection planning.
Conclusion
DAPTs are generally a terrible idea for core asset protection planning. Experienced asset protection lawyers know that FAPTs have a proven, favorable track record, whereas DAPTs have a string of court losses wherever challenged. We routinely caution fellow lawyers that advocating the use of an unproven DAPT may very well constitute professional malpractice and a breach of ethics if clients are not adequately informed of the risks of using a DAPT.
We do recommend the use of DAPTs when forming domestic trusts for other reasons, such as dynasty trust planning. Even then, however, it may be best to refer to a DAPT as a “DapT” using the lower-case letters “ap” to make clear that in almost no circumstance will a creditor be prevented from reaching trust assets. So, beware DapTs!
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