Litigation nation Asset protection for Americans

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1 Trust and fiduciary services Litigation nation Asset protection for Americans By Steve Sokic and Kelly Kerr Steve Sokic Private Client Director RBC Trust Company (International) Limited La Motte Chambers St Helier, Jersey JE1 1PB Phone: +44 (0) On February 27, 1992, Stella Lieback, a 79 year old woman from New Mexico purchased a 49-cent cup of coffee from the drive-through window of her local McDonald s restaurant. She was a passenger in a car driven by her grandson. After buying the coffee, her grandson parked the car so that Stella could add cream and sugar to her coffee. Stella placed the coffee between her knees while she removed the lid and accidentally spilled the coffee, resulting in third degree burns to her lap. The jury awarded Stella $160,000 in compensatory damages plus $2.7 million in punitive damages (albeit later reduced to $640,000). Kelly Kerr Manager, Trust Business Development Royal Bank of Canada Trust Company (Bahamas) Limited Lyford Cay House Western Road, PO Box N-3024 Nassau, Bahamas Phone: kelly.kerr@rbc.com The McDonalds case is now one of the most famous examples of what many believe was frivolous litigation. Labelled the poster child of excessive lawsuits by ABC News, it demonstrates just how vulnerable businesses and indeed individuals are to litigation. It is estimated that in the US alone, there will be 15 million lawsuits filed in While none of us have the absolute power to prevent litigation, measures can be taken to protect our personal estates from unforeseen attacks from creditors, ex-spouses or other disgruntled family members or heirs. One of the most common methods of asset protection is the use of trusts. In simple terms, a trust is an arrangement created when the owner of property (the settlor or grantor ) gives that property to another person (the trustee ) on terms which require the trustee to hold and manage that property for the benefit of a third person or group of persons (the beneficiaries ) which may, but need not, include the settlor. If a settlor creates a trust to be administered by a trustee located in a jurisdiction other than that of his residence or domicile, then the law of that jurisdiction, rather than that of his residence or domicile, is applicable. In that case, generally the law of the trustee s jurisdiction will be applicable as to the rights of creditors to access the

2 Trust and fiduciary services 2 beneficiaries interests in the trust fund. In principle, this permits a person who is domiciled in a jurisdiction which places restraints on alienation, to create a trust in another jurisdiction where there are no such restraints or are at least less onerous, thereby taking advantage of the law of the latter jurisdiction. Accordingly, the most common approach is to establish, and transfer a portion of assets to, a trust in a reputable foreign jurisdiction that offers robust judicial and statutory protection against future creditor claims, as well as other events that may compromise the composition of an estate. Where one of the principal motives for establishing a trust is to protect assets from unforeseen creditors, and its terms and characteristics reflect this, it is common for such a trust to be referred to as an asset protection trust or APT. That does not, however, mean that the potential benefits of the trust are limited to asset protection. The trust may, depending on an individual s circumstances, be advantageous from a tax perspective, serve as a valuable estate or succession planning tool and provide confidentiality. The APT approach There are a number of key considerations to be taken into account in order to properly establish a trust capable of successfully resisting challenges to its validity and future claims arising from creditors of the settlor: Timing The creation of a trust, and financial and estate planning in general, should always be undertaken proactively when the skies are clear and not as a reaction to an unfavourable or unwelcome event, particularly if asset protection is a key objective. A trust established after a claim has been made or was reasonably foreseeable at the time of its creation, is likely to be viewed by the courts as an attempt to defraud a creditor. Purpose Paradoxically, trusts established solely for asset protection may be perceived to be more vulnerable to attack. This is due to the fact that the creditors of the settlor may claim that the trust was set up purposely to avoid meeting existing debts. It is, therefore, advisable that the settlor also pursues other estate or tax planning objectives. Control An essential part of the APT arrangement is the gratuitous nature of the transfer of the property from the settlor to the trustee, the effective result being that the property transferred no longer belongs to the settlor. Furthermore, the terms of an APT deed would normally indicate that the trust is irrevocable (meaning the settlor may not unilaterally revoke the trust fund and take the trust assets back into his ownership). The powers over the trust fund are normally with the trustee in a fully discretionary manner; that is, a provision(s) in the trust agreement which gives the trustee sole discretion to distribute any amount, or all or none of the trust fund, to any one of a number of potential beneficiaries. This separation of ownership naturally results in a loss of control over the assets settled onto the trust (from the settlor to the trustee), which may understandably be a concern for some clients. However, when properly explained by his legal advisors and the trustee, this concern is normally mitigated, in part via (a) a clear outline of a trustee s fiduciary obligations, namely to the beneficiaries, and (b) the selection of a reputable and recognized trustee in an appropriate jurisdiction. Another possible approach is to consider a reserved powers or settlor directed trust. The typical powers that are reserved include the power to add and remove beneficiaries or trustees, the power to revoke the trust and the power to make investment decisions. While this type of trust may help to allay settlor fears regarding loss of control, serious care must be taken when reserving powers, particularly where the primary goal of the structure is protection against future creditor claims. It is possible, and indeed has been the case in the past, notwithstanding arguments of unfair duress, for a court to force a settlor to exercise his powers to his own detriment by forcing the settlor to change trustee or move the trust to another jurisdiction in order to make the trust assets accessible to a creditor. Self-settled trusts is another term coined in the US which refers to trusts where the settlor is also included in the class of discretionary beneficiaries, which in part helps alleviate the loss of control issue noted above. This is very common in offshore jurisdictions such as the Bahamas, Barbados and the Cayman Islands (hereafter collectively referred to as the Caribbean ) and Jersey and Guernsey (hereafter collectively referred to as the Channel Islands ). Finally, the settlor can provide guidance to the trustee through a non-legally binding document known as a letter of wishes. As the letter of wishes is not a legal document, the court cannot force the trustee to act upon the guidance given to it by the settlor. However, a submissive or weak trustee that treats

3 Trust and fiduciary services 3 the settlor s guidance as instructions and does not properly exercise its discretionary decision making powers will run the risk of the integrity of trust being called into question and, consequently, vulnerable to attack from creditors claiming that the assets continue to remain under the control of the settlor. Fraudulent conveyances Most of the fraudulent disposition laws across common law countries, such as the UK, Canada and the US, are based on an ancient piece of legislation called the Fraudulent Conveyances Act, or Statute of Elizabeth (the Statute ). Enacted in England in 1571, the Statute is widely acknowledged to favour the position of the creditor, principally because it renders void any disposition intended to defeat, delay or hinder the interests of creditors, and makes no distinction between existing and future creditors. What makes many offshore jurisdictions located in the Caribbean and the Channel Islands attractive foreign jurisdictions in which to establish APTs is their rather more neutral position with regard to the treatment of creditor claims. The Statute never became law in the Channel Islands and, while it was originally enacted across the Caribbean, it was repealed in the 1980s by most jurisdictions in the region who introduced their own, arguably more balanced, fraudulent disposition laws. Contrary to popular belief, many of the fraudulent disposition laws in the Channel Islands and the Caribbean are not designed to enable debtors to avoid their liabilities, but rather to strike a balance between the interests of the settlor and legitimate creditors. Part of this approach, is the existence of a timeframe within which claims against the trust must be made after disposition of assets to the trust, which stands at ten years in Guernsey and Jersey, six years in the Cayman Islands, three years in Barbados and two years in the Bahamas. Furthermore, a creditor can only have a disposition set aside if an obligation or liability (including a contingent liability) to the creditor existed at the date of the disposition of assets to the trust, and the person who made the disposition (the settlor) was, when he made it, aware that he owed or could potentially owe that obligation or was subject to the liability. Irrespective of when the trust was established, all fraudulent disposition laws in the Channel Islands and the Caribbean place the burden of proof on the creditor. Furthermore, case law in the Channel Islands also helped clarify the fact that any analysis of fraudulent intent (by a debtor) must establish a substantial purpose of a particular transfer to defeat creditors in order to progress any related action. Another advantage to establishing an asset protection trust in the Channel Islands or the Caribbean is the position that the countries in these regions take with regard to judicial comity. Whereas many jurisdictions will often give effect to the judicial decisions of another jurisdiction, trust jurisdictions in the Channel Islands and the Caribbean do not recognize or enforce foreign judgments. While the asset protections laws are broadly similar across the Caribbean and the Channel Islands, the main difference is that in the Channel Islands no claim can be brought unless the debtor was insolvent at the time of the disposition or was rendered insolvent by the disposition. Provided the settlor is solvent immediately following the disposition, the settlor will effectively obtain immediate protection from creditor claims from the date of the disposition without the need to await the expiry of the limitation period. Documentation and proof of such solvency status is an important extension of the above noted general principles, particularly if ever challenged in a court. Spendthrift provisions A spendthrift provision in an irrevocable discretionary trust is intended to prevent creditors from attacking the interest of the beneficiary in the trust before that interest (cash or property) is actually distributed to him. Well-drafted irrevocable trusts contain spendthrift provisions. This is because such a provision protects the trust and the beneficiary in the event a beneficiary is sued and a judgment creditor attempts to attack the beneficiary s interest in the trust. Moreover, trust statutes in the Channel Islands and the Caribbean contain specific provisions designed to limit the ability of creditors to recover the assets held in trust in the event of the bankruptcy of a beneficiary. Contingency fees and local lawyers Much of the frivolous litigation in the US is arguably as a result of the fact that US lawyers can act based on a contingency fee arrangement (otherwise known as no win no fee engagement). The Channel Islands and the Caribbean do not permit local lawyers to act for contingent fees. Furthermore, defendant trustees in the Channel Islands are perfectly entitled to ask for security for

4 Trust and fiduciary services 4 their legal costs if the plaintiff is a nonresident of Jersey or Guernsey (also commonly known as posting a bond ). Consequently, as a practical matter, it would have to be quite a serious adverse party who would come to the Channel Islands or Caribbean to overturn an APT. Constitution and selection Finally, the selection of trustee is as important as, or arguably more important than, the choice of trust jurisdiction. A landmark case formulated a test that confirms the existence of a trust which became known as the three certainties. This test specified that, for a valid trust, there must be certainty of: (a) intention (there must be intention to create a trust), (b) subject matter (the assets constituting the trust fund must be readily determinable), and (c) objects (the people to whom the trustees are to owe a duty must be readily determinable). Case law has shown that an aggressive creditor may attempt to argue that the trust to which settlements have been made was never a trust at all (not validly constituted/created in the first place). Moreover, they may argue that the trustee was not a trustee but rather simply a nominee custodian holding the assets transferred from the settlor. Such assets would, therefore, be directly owned by the settlor and thus subject to possible claims by creditors. Where the validity of the trust is not called into question, the residence of the trust for tax purposes might be challenged based on the true or actual mind and management of the trust, as was the case in the Garron decision(s) in Canada. There are very few provisions within offshore trust law that would help protect clients from such attacks. Quite often, the conduct of the trustee and extent of proper trust administration (or lack thereof) by the trustee is often a focus for creditors in substantiating such arguments. The only true defence is a proactive one; that is, having knowledgeable, reputable and experienced trustees in place at the onset (i.e., upon creation of the trust). Tax implications Generally speaking, when US persons establish foreign trusts to, at least in part, protect their assets from future litigation such trusts are effectively tax neutral and transparent under US tax law. Such trusts will normally be considered a grantor trust for US income and capital gains tax purposes. As a result, such trusts will effectively be transparent for US income and capital gains tax purposes and the settlor would be responsible for reporting and paying US tax on any realized income and gains within the trust annually. Notwithstanding such tax transparent status, there are required US tax filings with the IRS. Professional US tax advice from a qualified tax advisor is always recommended prior to embarking upon the establishment of a foreign trust. Conclusion In this increasingly litigious world, particularly for those in or with connections to the US, private estates are more vulnerable to attack than ever before. High net worth individuals around the globe recognize the importance of taking reasonable precautions to ensure that their estates are protected against unforeseen future claims or circumstances that may compromise their security. Provided it is established with proper legal counsel and a reputable and competent trustee and at a time when there are no existing or foreseeable claims against the settlor, a trust can be one of the most effective asset protection tools available.

5 Trust and fiduciary services 5 Royal Bank of Canada, which operates under the brand name of RBC, is Canada s largest bank, one of North America s leading financial services companies, and among the largest banks in the world as measured by market capitalization. Through a network of offices worldwide, RBC provides comprehensive wealth management services to high net worth individuals and institutions resident in over 150 countries. This publication has been issued by Royal Bank of Canada on behalf of certain RBC companies that form part of the international network of RBC Wealth Management. RBC Wealth Management offers trust and fiduciary services via the principal operating companies detailed below. Services outlined may be provided by a variety of Royal Bank of Canada subsidiaries and offices, either independently or acting together, operating in a number of different jurisdictions. You should note that the applicable regulatory regime, including any investor protection or depositor compensation arrangements, may well be different from that of your home jurisdiction. Some of the services detailed in this document are not offered in all jurisdictions and may not be available to you. You should carefully read any risk warnings or regulatory disclosures in this document or any other literature enclosed with this document or forwarded to you by Royal Bank of Canada s subsidiaries or affiliates. This document is intended as general information only and is not intended as tax, legal, investment or other professional advice. You should always obtain independent professional advice particular to your individual circumstances. The information in this document is based on sources considered reliable at the time, but no representation is made regarding its completeness or accuracy and no obligation is undertaken whatever to update it for any changes of law or interpretation. Royal Bank of Canada, its affiliates and subsidiaries and their officers, directors, employees and agents are not responsible for and will not be liable to you or anyone else for any damages whatsoever (including direct, indirect, incidental, special, consequential, exemplary or punitive damages) arising out of or in connection with your reliance on the document, even if the Royal Bank of Canada, its affiliates or subsidiaries or their officers, directors, employees or agents have been advised of the possibility of these damages. IRS Circular 230 Notice: To ensure compliance with requirements imposed by the Internal Revenue Service (IRS), we inform you that in compliance with the U.S. Federal Tax Regulations, unless expressly stated in writing otherwise, any discussion of tax matters contained in this communication (or any attachment hereto) is not intended or written to be used as and cannot be used as or considered to be a covered opinion or other written tax advice; and should not be relied upon by any person for the purpose of (i) avoiding any Internal Revenue Code (IRC)-related penalties that may be imposed on a taxpayer or (ii) promoting, marketing or recommending to another party any transaction or tax-related matter(s) addressed herein (or attachments hereto) for IRS audit, tax dispute or any other purpose. The addresses and main regulators of the principal RBC Wealth Management companies providing trust and fiduciary services: Royal Bank of Canada Trust Company (Bahamas) Limited: Lyford Cay House, Western Road, P.O. Box N-3024, Nassau, NP Bahamas: Regulated by the Central Bank of the Bahamas. Royal Bank of Canada (Caribbean) Corporation and Royal Bank of Canada Financial Corporation: Chelston Park, Second Floor, Building 2 Collymore Rock, St Michael, Barbados: Regulated by the Central Bank of Barbados. Royal Bank of Canada Trust Company (Cayman) Limited: 24 Shedden Road, Royal Bank House - 4th Floor, PO Box 1586, George Town, Grand Cayman KY Cayman Islands: Regulated by the Cayman Islands Monetary Authority. RBC Trust Company (Delaware) Limited: 4550 New Linden Hill Road, Suite 200, Wilmington DE 19808: Regulated by the State of Delaware Office of the State Bank Commissioner. Roycan Trust Company SA: PO Box 5484, Rue de la Fontaine 2, 1204 Geneva, Switzerland. RBC Trustees (Guernsey) Limited: PO Box 48, Canada Court, Upland Road, St Peter Port, Guernsey GY1 3BQ, Channel Islands: Registered company number 37379: Regulated by the Jersey and Guernsey Financial Services Commissions. Royal Bank of Canada Trust Company (Asia) Limited: 17th Floor, Cheung Kong Center, 2 Queen s Road Central Hong Kong: Regulated by the Mandatory Provident Fund Schemes Authority. RBC Trust Company (International) Limited: La Motte Chambers, St Helier, Jersey JE1 1PB, Channel Islands: Registered company number 57903: Regulated by the Jersey Financial Services Commission Royal Bank of Canada Trust Corporation Limited: Riverbank House, 2 Swan Lane, London, EC4R 3BF. RBC Trust Company (Singapore) Pte.Ltd: 3 Church Street, #27-01/08 Samsung Hub, Singapore, : Registered company number K: Regulated by the Monetary Authority of Singapore (licence number TC ). Registered trademark of Royal Bank of Canada. Trademark of Royal Bank of Canada. Used under licence. ADV/11/ (12/11)