Spendthrift clauses get a new limitation

In recent opinion, the 9th U.S. Circuit Court of Appeals did as expected, reversing a decision of the Bankruptcy Appellate Panel following the California Supreme Court's opinion in response to a certified question. In Frealy v. Reynolds, 2017 DJDAR 7871 (Aug. 15, 2017), at issue has been when creditors can reach trust distributions and to what extent. The trust in question contained a spendthrift clause and only held undeveloped land, which qualified as principal and not income.

Ambiguities in the California Probate Code led to disagreements among courts. Under the current ruling, a bankruptcy estate is entitled to reach the total amount of spendthrift trust distributions "due to be paid." However, any amounts needed for support or education cannot be reached if the trust specifies that the amount is to be used for such purpose. The estate can also reach 25 percent of expected future payments from the spendthrift trust, less amounts needed for the support of the beneficiary or dependents. While this ruling clarifies ambiguities in the California Probate Code, it also decreases the protection against creditors for a spendthrift trust.

The case has been closely watched for the past few years. In March 2015, the 9th Circuit asked the California Supreme Court: "Does section 15306.5 of the California Probate Code impose an absolute cap of 25 percent on a bankruptcy estate's access to a beneficiary's interest in a spendthrift trust that consists entirely of payments from principal, or may the bankruptcy estate reach more than 25 percent under other sections of the Probate Code?" Frealy v. Reynolds, 779 F.3d 1028 (9th Cir. 2015). The other sections at issue include Probate Code Sections 15301(b) and 15307, and each could potentially create different outcomes.

The California Supreme Court responded earlier this year, as reflected in Carmack v. Reynolds, 391 P.3d 625, 628 (Cal. 2017). Essentially, the court set the cap at 25 percent, limited by the above mentioned support and education requirements. Less clear is the potential outcome should the trust payments consist of both income and principal.

The facts of the case are relatively simple. Rick Reynold's parents established a trust in which he was a beneficiary after they both died. Reynolds filed a Chapter 7 bankruptcy petition one day after his father, the second parent to die, passed away. The (trust) trustee commenced a proceeding requesting that the bankruptcy court determine the bankruptcy trustee's interest in the trust.

The trust contained a spendthrift provision which stated: "No interest in the income or principal of any trust created under this instrument shall be voluntarily or involuntarily anticipated, assigned, encumbered, or subjected to creditor's claim or legal process before actual receipt by the beneficiary." Atypically, the trust was to only make disbursements from principal due to the assets being limited to non-income-producing undeveloped land. Reynolds became entitled to an immediate $250,000 payment upon his father's death, followed by $100,000 per year for 10 years, plus one-third of the residue from a sub-trust.

The case was initially heard in bankruptcy court. That court held that the bankruptcy trustee, standing as a hypothetical lien creditor and under California Probate Code Section 15306.5, was entitled to reach a maximum of 25 percent of Reynolds' interest in the spendthrift trust (only), and that the code section established this maximum cap. This opinion was affirmed by the 9th Circuit Bankruptcy Appellate Panel. Unhappy with the result, the Chapter 7 trustee appealed to the 9th Circuit based upon two different arguments. The first claimed that the estate should be able to reach more than 25 percent because Section 15301(b) of the Probate Code gives creditors unrestricted rights to distributions of principal "due and payable," and Reynolds' trust distributions were all to be made from principal. Second, and alternatively, the trustee stated that Section 15307 allows a bankruptcy estate to attach any amount of Reynolds' trust interest not required for his education and support. Principal and income are treated differently with respect to creditors, and various exceptions exist.

The 9th Circuit could find no way of aligning its understanding of Section 15306.5 with Sections 15301(b) and 15307. Therefore, it asked the California Supreme Court to clarify the ambiguities and the Supreme Court granted the 9th Circuit's request.

To settle the seemingly conflicting code provisions, the Supreme Court evaluated the various code provisions at issue along with their legislative history, which included an attempt to resolve other past ambiguities in earlier code sections. What the Legislature had striven earlier to fix led to new uncertainties. The court commenced its analysis by looking at Probate Code Section 15301. Section 15301(a) is clear that principal held in a spendthrift trust cannot be touched by creditors until actually due to a beneficiary. However, Section 15301(b) states that when an amount of principal becomes due and payable to the beneficiary, a judgment creditor can petition the court for an order directing the (trust) trustee to satisfy their judgment from this principal amount, except to the extent all or a portion is needed for the beneficiaries support or education. "Due and payable" was defined by the court as "those amounts which are presently set to be paid to the beneficiary." Essentially, the creditor could touch those amounts due now, but not amounts to be paid in the future. Importantly, once principal became "due and payable" spendthrift protections no longer apply to them.

The Supreme Court next analyzed Sections 15306.5(b) and 15307. Under Section 15306.5(b), payment to a judgment creditor is limited to 25 percent of the payment that otherwise would be made to the beneficiary. In contrast, Section 15307 says that any amount to which the beneficiary is entitled, above that needed sum for support and education, can be applied to satisfy a creditor's judgment. The court reviewed legislative history, deciding that that Section 15307 "reflects a drafting error," to align the disconnect between code sections. The court further stated that the legislature had intended general creditors to be limited to 25 percent of distributions from the trust, as demonstrated as well in other very carefully constructed code sections.

The court determined that a judgment creditor can require payment of the full amount of a principal distribution currently "due and payable," but also stated that payments to a creditor are restricted to 25 percent of payment that "otherwise would be made." The section wording was very important in the analysis. Therefore, the 25 percent restriction is only applicable to future payments of principal that will become payable later (as opposed to currently). The court did not address income payments, and whether those currently due and payable are also subject to creditor claims.

The court added an example. If a creditor is due $50,000 and the beneficiary is to receive $10,000 a year for five years, the creditor can reach the initial $10,000, plus $2,500 each of the following four years. If it cannot satisfy the rest of the balance due, it can attach $7,500 each year when that amount is to be paid to the beneficiary until the total amount due is paid off. The example assumes that the funds aren't needed for the beneficiary's support and education.

Overall, the beneficiaries of spendthrift trusts now have a lower level of protection from creditor claims, especially where principal is concerned. In practical terms, certain types of creditors have long had preference with respect even to spendthrift trust payments. For example, beneficiaries cannot simply avoid support obligations like alimony or child support, and individuals cannot shelter sums from creditors by creating a trust in which they are both settlor and the beneficiary. Realistically, the possible risk that income payments will likewise be less protected has yet to be determined, but is now subject to uncertainty. When drafting such spendthrift trusts, language specifying that principal is to be used for the beneficiaries' support and education is important as it protects some principal. Settlors should also be aware that while trusts do provide a level of creditor protection, wording, timing and classifications of payments are key factors in how much. And when code provisions conflict, a smart lawyer just might persuade a court to rule in a client favorable manner.