Limits on the Protection of a Spendthrift Trust?

Take-Away: Despite a broadly phrased spendthrift provision in a trust, there still can be narrow situations where a creditor may be able to access the beneficiary’s income interest in the spendthrift trust.

Background: The Michigan Trust Code defines a spendthrift provision as a term of a trust that restrains either the voluntary or involuntary transfer of a trust beneficiary’s interest in that trust. [MCL 700.7103(j).] This definition is one of those rare situations where Michigan did not adopt the Uniform Trust Code’s proposed definition. The difference is that the Uniform Trust Code defines the spendthrift provision as one that restrains both the voluntary and involuntary transfer of a beneficiary’s interest. [UTC 103(16).] Michigan’s definition refers to either a voluntary or involuntary transfer that is covered by the spendthrift limitation. Under the Michigan Trust Code, a spendthrift limitation is valid and enforceable. [MCL 700.7502(1).] There are a handful of what are called exception creditors described in the Michigan Trust Code who may still access a beneficiary’s interest in the trust despite the presence of a spendthrift provision in the trust: child support and spousal support obligations; judgment creditors who provide services that preserve or protect the beneficiary’s interest in the trust; and claims held by the State of Michigan and the United States. [MCL 700.7504(1).] But there may be other times when a creditor can access a beneficiary’s interest in a spendthrift trust that may not fall within the identified exception creditor categories.

King v. King, 295 Or. App. 176 (December 5, 2018): Consider the King decision, which refers to the common law distinction between an internal and external creditor of the beneficiary of a spendthrift trust.

• Basic Facts: David and Sandra were married in 1996. It was a second marriage for each. David died in 2004. On his death David exercised a general power of appointment that his father had created for him under another trust, so that upon David’s death with the exercise of that power of appointment, David created a testamentary ‘family trust’ in which Sandra was given the right to all trust income, with the remainder interest in the ’family trust’ ultimately passing to David’s children. Sandra was in her 60’s at the time of David’s death. Sandra, David’s brother and David’s sister-in-law were all appointed Co-trustees of the ‘family trust.’ David’s brother resigned shortly after David’s death. David’s sister-in-law, continued on for a few years as a co-trustee, but apparently she paid little or no attention to the administration of the ‘family trust’, effectively leaving Sandra, David’s widow, as the sole acting trustee of the ‘family trust’ where she was also the income beneficiary for life. The trust was a bit unusual. It was drafted by a Minnesota attorney and the trust incorporated Minnesota statutory trustee powers, yet the trust was expressly governed by Nevada law, where David and Sandra lived when David’s Will, which exercised the testamentary power of appointment, was signed and admitted to probate. David and Sandra lived in Oregon at the time of his death, which explains the involvement of Oregon courts.
• Trustee Activities: Sandra, acting practically speaking as the sole trustee, made a series of decisions as trustee over the years until 2011 when a petition was filed by David’s three children from his prior marriage to remove Sandra as trustee. The children’s petition also asked the court to surcharge Sandra for several ‘investment’ decisions that she made in her role as trustee. Among Sandra’s actions challenged by the children, she: (i) loaned $1.0 million to herself to purchase and remodel a home; (ii) loaned $950,000 to herself to remodel a home in Minnesota; (iii) loaned $180,000 to an LLC winery in which she was a member with her son from her prior marriage; and (iv) on multiple occasions when a distribution was made to the trust e.g. income from mineral investments, Sandra treated the entire distribution as distributable income to her, and thus she failed to follow the Uniform Principal and Income Act which required that a part of those distributions had to be treated as principal of the trust.
• Trial Court: After a 4-day hearing, the trial court in Oregon held for the David’s children, noting:

“By and Large [Sandra] treated the assets of the trust as her own without regard to whether those assets were to be treated as income or principal, she entered into a number of poorly secured or totally unsecured large insider transactions that constituted per se breaches of trust under Nevada law, she failed to properly and timely account and she generally ignored or was completely oblivious to the rights of petitioners and the fiduciary duties she owned them as contingent remainders of the trust.”

Accordingly, the trial court entered orders to: (i) remove Sandra as trustee; (ii) surcharge her $913,247; (iii) impose a constructive trust on two properties that she had loaned money to her son from her first marriage to acquire; and e(iv) awarded attorney’s fees to David’s children, an award that was made jointly against both Sandra and the testamentary trust. However, the trial judge rejected the request of David’s children to order the income that Sandra was entitled to receive from the ‘family trust’ be diverted to pay down over time the surcharge amount imposed against Sandra-acting-as-trustee, since the trust contained a comprehensive spendthrift provision consistent with Nevada’s statutes. David’s children appealed the refusal to use the trust’s income stream to pay down their surcharge award; the children claimed that the surcharge against Sandra as trustee could be satisfied from her right to receive all of the income from the ‘family trust’ as its sole income beneficiary as their claim against her was internal, meaning that it arose from her negligent administration of the trust.

• Appellate Court: The Oregon Appeals Court found that, but for the presence of the spendthrift clause in the ‘family trust’, there was no question that surcharge of the trustee-beneficiary’s interest was the appropriate remedy for a breach of fiduciary duty. As for the protection that would be provided by the trust’s spendthrift provision the Court noted:
• “The text of the [Nevada] statute provides that ‘payments’ ‘the income’ and ‘the interest of the beneficiary’ may not be directed away from the beneficiary by voluntary or involuntary acts, including court orders; rather ‘the whole of the trust estate and the income of the trust estate shall go to and be applied by the trustee solely for the benefit of the beneficiary, free, clear, and discharged of and from any and all obligations of the beneficiary whatsoever and of all responsibility therefore’. NRS 166.120(2)3). Although the text is worded broadly, it is written in terms of creditors and proceedings that are external to the affairs of the trust. Because breach-of-trust proceedings differ from all other types of proceedings in that they are internal to the trust and logically precede a trustee’s determination of the beneficiaries’ interests for distribution purposes, it is not clear that NRS 166.120 is intended to apply to them…. As explained above, all three Restatements of the Law of Trusts recognize that a spendthrift provision does not prevent application of the rule that a breaching trustee-beneficiary’s interest can be applied to compensate other beneficiaries for losses incurred because of the breach of trust. ..Given those circumstances, we concluded that the Nevada Legislature did not intend NRS 166.120 to prohibit a surcharge of the breaching trustee-beneficiary’s interest as a remedy for the trustee-beneficiary’s own breach of trust. “
• Thus, the Oregon Court of Appeals found a common law exception, cited in all three Restatements of Trusts, to the trust’s broad spendthrift provision when there exists an internal breach-of-trust claim, which permits applying a beneficiary’s interest in the trust to compensate the trust and other trust beneficiaries for losses that a trial court has previously found were caused by the trustee’s breaches of trust resulting in a surcharge.

Conclusion: The King litigation and court decisions stand as a ‘poster-child’ for why second spouses should never act as sole trustee of a trust where the deceased’s spouse’s children from a prior marriage hold the remainder interest in the same trust. It also is a sad, all-too-often recurring example of how individual successor trustees who are also trust income beneficiaries tend to view all of the trust assets as their own assets, completely ignoring the interests of the remainder beneficiaries. While Mr. King probably thought that initially adding his brother and sister-in-law as co-trustees with Sandra would inject a level of objectivity into the administration of the ‘family trust’ that was created on his death, that ‘plan’ quickly went awry with his brother’s resignation and his sister-in-law’s lack of understanding of her responsibilities as a named co-trustee. Finally, it was interesting to note that the court was quick to find a breach of fiduciary duty by the trustee when she failed to follow the correct allocation of principal and income when distributions were made to the trust. How many individual trustees have the even remotest idea of what the Uniform Principal and Income Act requires with respect to allocations between income and principal? This is a sobering decisions of why it may not be a good idea to name a non-professional, income beneficiary as the trustee of an irrevocable trust, like a conventional credit-shelter trust. There is no question that Sandra overreached in her role as the acting trustee of the ‘family trust’ deciding what was income (or not) and making unsecured loans to non-trust beneficiaries. In many cases, where step-children are the remainder trust beneficiaries, the likelihood of a challenge by them as to the administration of the trust by their step-parent is usually an invitation to probate litigation.