Ohio: Latest State to Offer Bogus Asset Protection

In December 2012, Ohio passed legislation creating the “legacy trust” — its entry in the domestic asset-protection-trust derby — with provisions favoring the use of Ohio trustees and Ohio banks. As with DAPT legislation in other states, caveat emptor governs. Clients relying on the Ohio legacy trust for asset-protection purposes are likely to be sorely disappointed; counsel recommending it as an asset- protection device ought to expect malpractice exposure.

The most profound weakness of any DAPT is that the Full Faith and Credit Clause obliges a state court to recognize and enforce another state’s judgments. An Ohio court cannot rely on the protective provisions of Ohio law in the face of another state’s judgment that a transfer to the legacy trust was a fraud on creditors.

Many commentators have suggested that DAPT laws in Nevada, Alaska, or Delaware would only protect residents of those respective states. If an Illinois resident settled an Ohio legacy trust, an Illinois court could ignore Ohio law and grant judgment against the trustee or the trust assets under Illinois law. Some lawyers theorize that an Ohio-resident settlor might fare better. But out-of-state creditors readily obtain diversity jurisdiction against an Ohio resident in federal court. The Ohio legacy trust may, at best, protect the assets of an Ohio resident against an Ohio-resident creditor where both the trustee and the trust assets are uniquely situated in Ohio. Threading that needle strains credulity.

Even on a perfect set of facts in which the Full Faith and Credit Clause might not be invoked, recent rulings in Alaska and Hawaii show how vulnerable DAPTs are in bankruptcy. See Battley v. Mortensen, Adv. D.Alaska, No. A09-90036-DMD, May 26, 2011; In re Zukerkorn, 2012 WL 6608887 (9th Cir. BAP (Cal.), Dec. 19, 2012). Bankruptcy in the United States is federal law; § 548(e) of the Bankruptcy Act includes a ten-year clawback for assets transferred by a bankrupt settlor into a spendthrift trust. Ten years is a long time to wait for certainty.

Lining up the weaknesses, DAPTs offer very little to a trust settlor that other instruments do not. Trust beneficiaries continue to enjoy all the protections of traditional spendthrift trusts in most U.S. states. DAPT legislation appears, in practice, to prop up the marketing of trust companies and lawyers selling vacuous protection to settlors. Settlors could save themselves substantial cost by using a traditional spendthrift trust to protect the assets from the reach of beneficiary creditors.

On the harder question — protecting trust assets from the settlor’s creditors — there is no domestic substitute for the foreign asset-protection trust:

1. With a DAPT such as the Ohio legacy trust, the client may have arguable protection only if the client and the creditor are both Ohio residents, the dispute is governed by Ohio law, and the trustee and assets are situated in Ohio. With a FAPT, protection is in place from the day the trust is settled.
2. Even on facts that satisfy condition (1), the DAPT is vulnerable in bankruptcy. The FAPT is not — the trust assets are immune from the reach of the bankruptcy court.
3. FAPTs are cheaper to establish and maintain than DAPTs, with as much flexibility as a traditional spendthrift trust.
4. On case law: there are very few published DAPT cases, and what there is bodes badly for them. FAPTs have been used successfully for generations; the Cook Islands alone has more than two decades of confirming case law.
5. Ohio’s legacy trust, like other DAPT statutes, requires the use of an Ohio trustee. Move out of state and the protection (such as it is) becomes harder to preserve. Change trustees mid-litigation and it becomes effectively impossible.
6. Trustee liability is the next pressure point. Under trust law, a trustee is personally liablefor a fraudulent transfer. Domestic trustee companies have generally assumed they could simply return the settlor’s assets and wash themselves of liability; that liability remains where the assets have been exhausted. Expect domestic trustee companies to become increasingly selective, and expect domestic banks serving as DAPT trustees to withdraw from the work.

The firm favors domestic planning whenever it works. The Ohio legacy trust is not such a planning device. Ohio residents and their counsel are better served by an Ohio LLC paired with a foreign asset-protection trust as member; the result is materially superior to the legacy trust on every dimension that matters.