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George F. Bearup, J.D. Senior Legal Trust Advisor

16-Mar-21

Spendthrift Provisions and Nonjudicial Settlement Agreements

Take-Away: A non-judicial settlement agreement cannot be used to terminate or modify the terms of a trust. The presence of a spendthrift provision in a trust might be sufficient, however, by itself, to preclude the use of a non-judicial settlement agreement.

Background: The adoption of the Michigan Trust Code in 2010 brought with it the possible use of a nonjudicial settlement agreement. [MCL 700.7111.] Michigan’s statute closely follows the Uniform Trust Code (UTC, Section 111) version of a non-judicial settlement agreement. There are, however, limits to what can be accomplished with a nonjudicial settlement agreement.

“A nonjudicial settlement agreement is valid only to the extent it does not violate a material purpose of the trust and includes terms and conditions that could be properly approved of by the court under this article or other applicable law. A nonjudicial settlement agreement shall not be used to accomplish the termination or modification of the trust.” [MCL 700.7111(2).]

As such, a nonjudicial settlement agreement is normally used with regard to changes to the administration of an irrevocable trust or with respect to the interpretation or construction of the trust’s terms. In contrast, if a probate court is asked to modify the terms of the trust, there is no reference to the need to preserve the trust’s material purposes. [MCL 700.7410 (1).]

Material Purpose: As we have previously covered, the Michigan Trust Code does not define material purpose. However, many courts refer to the Restatement (Second) of Trusts, Section 337(2) which describes the material purpose rule as follows: “If the continuance of the trust is necessary to carry out a material purpose of the trust, the beneficiaries cannot compel its termination.” The very nature or design of a trust suggests its protective nature or some other material purpose. Restatement (Third) of Trusts, section 65, comment (d). Some trust instruments go to great length to identify the settlor’s material purposes of his or her trust. Other trust instruments are silent, which can lead to guesswork as to what the settlor intended to be the material purposes of his or her trust.

The Nebraska Supreme Court issued a decision last month in which found that a nonjudicial settlement agreement was invalid, but not because it sought to modify the trust’s distribution provisions per se, but merely because the trust contained a spendthrift provision.

In re Trust Created for Clifford Allen McGregor, 308 Neb. 405 (published February 12, 2021)

Facts: Cliff and his wife, Evelyn, each had their own trust. They divided their assets equally between their two trusts. Cliff and Evelyn were named as co-trustees of both trusts. Cliff died in October of 2009. On Cliff’s death, Evelyn became the sole acting trustee of his irrevocable trust. All of the assets in Cliff’s trust passed to a credit shelter (“Family”) trust, of which Evelyn was the income beneficiary for her lifetime. On Evelyn’s subsequent death, the assets in the Family trust were to then be divided into ‘continuing’ trusts for the benefit of each of their two children, Allen and Debra, and their children’s issue. Each child was to act as the trustee of their separate continuing trust and each was a discretionary beneficiary under a HEMS distribution standard. The child was to be a priority beneficiary of their respective continuing trust before distributions could be made to their issue from the continuing trust. Specific real property assets were to be allocated to each of the continuing trusts, with a direction to the trustee to attempt to use the remaining liquid assets, if available, to equalize the two continuing trusts. However, Cliff’s trust made it clear that there was no obligation to implement an equal allocation of assets to the two continuing trusts if there were insufficient liquid assets to accomplish the full equalization.

Spendthrift: Cliff’s trust, as did Evelyn’s, contained a conventional spendthrift prohibition, in which the trust instrument explained that the continuing  trusts for their children and their issue was “a non-support discretionary spendthrift trust that may not be reached by the beneficiaries’ creditors for any reason.”

Settlor’s Intent: In addition, Cliff’s trust contained the following language: each continuing trust “shall be irrevocable, shall remain in trust, shall not be revoked or amended in whole or in part by the trustee, the beneficiary or any other person.” 

Nonjudicial Settlement Agreement: In May of 2011, Evelyn, Allen and Debra entered into a nonjudicial settlement agreement. Specific parcels of real estate were to be allocated to Allen’s continuing trust on Evelyn’s subsequent death from the Family trust. In addition, rather than hope for an equalization of assets that were to pass to the Allen and Debra’s continuing trusts on Evelyn’s death, the trustee was directed under the nonjudicial settlement agreement to equalize the distributions between the two continuing trusts. Finally, the agreement provided for the direct distribution of the continuing trust assets to Allen and Debra on Evelyn’s death, effectively abandoning the continuing trusts upon Evelyn’s subsequent death. 

Dispute: In May, 2017 Evelyn sent an email to Allen in which she claimed to revoke the nonjudicial settlement agreement. In July, 2018 Allen filed a petition with the local trial (probate) court to approve the nonjudicial settlement agreement. Evelyn objected to the petition; she claimed that the agreement was not binding, that the agreement violated a material purpose of Cliff’s trust, and that the agreement was not signed by all of the interested persons in Cliff’s trust, i.e. Debra and Allen’s issue, or potential appointees under limited powers of appointment over the continuing trusts held by Allen or Debra.

Trial Court: The trial judge ruled against Allen’s petition. The judge found that the nonjudicial settlement agreement was contrary to the material purposes of Cliff’s trust because of the presence of the spendthrift language.

Nebraska Supreme Court: While several arguments were raised on appeal, e.g. who were interested persons who needed to sign the nonjudicial settlement agreement, the Court relied exclusively on the trial judge’s conclusion that the nonjudicial settlement agreement violated the material purposes of Cliff’s trust’s because of the spendthrift provision.

  • The Restatement (Second) of Trusts, Section 337, comment (l), prohibits the modification of a trust if the trust’s material purpose would be frustrated.
  • Relying on a Supreme Court of Kansas decision and an earlier Nebraska decision, the Court noted that the presence of a spendthrift provision prevents a trust’s termination (or modification): “If by the terms of the trust…the interest of one or more of the beneficiaries is made inalienable…the trust will not be terminated while such inalienable interest still exists, although all of the beneficiaries desire to terminate it.” This was presented as a rule of construction at common law.
  • “The trust settlement agreement violates this fundamental and material purpose of the trust, because the agreement distributes estate assets to the beneficiaries outright rather than in trust. This provision of the agreement would allow the assets to ‘be reached by the beneficiaries [‘] creditors and would allow Allen and Debra to transfer the assets during their lifetimes, which directly conflicts with the limited power of appointment provided in the carve-out [continuing] trusts.”
  • “We find no evidence offered by Allen to rebut the presumption that the spendthrift provisions constitute a material purpose of the trust.”
  • “We conclude that the spendthrift provisions of the Family Trust established a material purpose of the trust, which the settlement agreement violates by transferring the trust assets to Allen and Debra outright rather than in trust. Because the agreement violates a material purpose of the trust… the agreement is invalid.”

Observations:  The material purpose language in MCL 700.7111(2) poses a problem with respect to the modification or termination of a trust that contains a spendthrift provision by way of a nonjudicial settlement agreement. Most trusts routinely include a spendthrift provision without the settlor even knowing the limitation is in the trust (unless the settlor is an engineer, since the engineers read everything, including each trust boilerplate provision!)

  • UTC: The comments to UTC 411(c) ‘assumes that spendthrift provisions are often added without little thought.” Consequently, the comments to the UTC Section 411(c) make it clear that inclusion of a boilerplate spendthrift provision in a trust instrument “is not presumed to constitute a material purpose of the trust.”
  • Common Law: As noted in the Nebraska Supreme Court’s decision, there is a presumption at common law that the presence of a spendthrift provision in a trust is a material purpose of the trust. Many states that have adopted some variation of the UTC have provided in their versions of that uniform law that a spendthrift provision in a trust is not presumed to be a material purpose of the trust, consistent with the UTC’s comments.
  • Michigan’s Trust Code: Going back to Michigan’s nonjudicial settlement agreement statute, i.e. MCL 700.7111(2), if a spendthrift provision is presumed to be a material purpose (consistent common law) then any nonjudicial settlement agreement will always be invalid, since the trust contains a spendthrift provision. Which is why many states no longer follow the common law presumption that the presence of a spendthrift provision is presumed to be one of the trust’s material purposes.

The Michigan Trust Code includes the provisions for modifying or terminating trusts. [MCL 700.7411(b) and (c). Neither of those provisions include the requirement found in MCL 700.7111(2) that alteration be consistent with the material purposes of the trust or that continuance of the trust is not necessary to achieve any material purpose.

The Michigan Trust Code did not adopt the UTC’s presumption-reversing language with regard to spendthrift provisions. This was a conscious decision of the drafters of the Michigan Trust Code.

That presents a dilemma for beneficiaries who seek to modify or terminate a trust with the use of a nonjudicial settlement agreement. Because a nonjudicial settlement agreement cannot violate a trust’s material purpose, any challenge to the nonjudicial settlement agreement places the material purpose question squarely before the probate court. Restated, rather than achieve a nonjudicial settlement solution to a question, the use of the nonjudicial settlement agreement may not be effective, and could lead to costly probate court proceedings that inquire into the materiality of the trust’s spendthrift provision. Thus, it may prove to be a hollow remedy if most trusts contain a spendthrift provision.

  • Potential Solution: Inasmuch as trusts tend to be mobile these days, it might make sense to add to a trust’s spendthrift provision that its presence is not a material purpose of the trust if the thought is that the trustee and trust beneficiaries may at a later date wish to engage in a nonjudicial settlement agreement to modify the terms of the trust, e.g. a dynasty-type of trust that may run for several generations.  With this language in place, much of the uncertainty that surrounds a nonjudicial settlement agreement that seeks to modify or terminate the trust’s spendthrift protection can be avoided.

Conclusion: I do not disagree with the decision of the Nebraska Supreme Court. However, it could easily have reached the same decision merely by focusing on the settlor’s express statement of intent provision in his trust ‘’this trust shall be irrevocable, shall remain in trust, shall not be modified or amended in whole or in part by the trustee, beneficiary, or any other person.’ That provision clearly expresses the settlor’s intent- no modification, ever. Instead, the Court based its decision on the presence of the trust’s spendthrift provision and the presumption at common law that the spendthrift limitation was intended by Cliff as a material purpose of his trust. The result was based on a presumption, rather than the language used in the trust.