The Increasing Use of International Trusts
Are Your Clients Prepared for the Next Economic Crisis?

by Philip R. Rupprecht

From all appearances, Phoenix and its real estate market have rebounded from the steep downturn in the early ’90s. New home construction is booming and real estate developers are back in business in a big way. It is easy in such an environment to forget the economic upheaval of only a few years ago. But business trends run in cycles, and today’s upswing is inevitably a precursor to tomorrow’s downturn.

In the heyday of real estate development, personal liability seemed unimportant. When the market reversed in the late 1980s, however, businessmen and women all over Arizona suddenly got a very rude awakening. These once high-flying businesspeople found their entire net worth at risk either because they were general partners in insolvent partnerships or because they guaranteed substantial bank debt.

A great many lawyers had clients in the late ’80s and early ’90s looking for protection from overwhelming financial problems. At one time, it appeared that a strapped real estate developer could potentially avoid liability by asserting lender liability claims. A Court of Appeals’ decision and a change in the law soon foreclosed this theory as a defense in many cases.¹ When the Resolution Trust Corporation took over virtually the entire Arizona savings and loan industry, many other defenses were barred by the D’oench Duhme doctrine.²

Real estate investors (and many others) who survived the economic chaos of the past decade are now looking for a way to position themselves to better survive the next downturn. Perhaps still feeling the pain of unforeseen market changes, many clients are now seeking prevention against such ills rather than a cure after acquiring the disease. In addition, they want the best of both worlds. They want to structure their financial affairs in such a way that they can still conduct business, yet, at the same time, protect their assets in the event of a market crash or unfavorable verdict.

Protecting assets takes many forms, to be sure. Pension plans, homesteads, family limited partnerships and the like all have their place, but offer only limited protection. In the April, 1997 Arizona Attorney, James O. Ehinger detailed the considerable issues and problems faced by creditors trying to recover on a U.S. judgment overseas.³ Mr. Ehinger’s article effectively highlights the asset protection advantages inherent in the use of offshore entities. One of these entities, the international trust, appears to offer both the greatest flexibility and the greatest asset protection to those seeking to avoid a repeat of the early 1990s.⁴

People once thought offshore trusts were the exclusive province of the sophisticated ultra-rich or cleverly corrupt. With the increasing recognition of these structures and certain changes in the law, the costs and risks of international trusts have decreased considerably. Now, professionals, business owners and many others find them a useful, effective, cost-efficient — and perfectly legitimate — asset protection and estate planning tool.

Basic Structure of an International Trust

Some have touted international trusts as the ultimate asset-protection device.⁵ Typically, an individual concerned about protecting assets from future potential creditors contributes cash, securities, and/or real estate to a trust settled under the law of a foreign jurisdiction, such as Belize, Nevis or the Cayman and Cook Islands. Two associates of the grantor serve as domestic trustees, with a third corporate trustee from the trust domicile. The beneficiaries of the trust can include the grantor, the grantor’s spouse, the grantor’s family and any other persons or charities the grantor may wish. Under the terms of the trust indenture, all beneficiaries are discretionary. Many foreign jurisdictions allow the grantor to serve as a "protector" who holds the power to veto investment and distribution decisions. The trust then establishes a domestic limited partnership (or partnerships) contributing as the initial capital most, if not all, of the same assets. The international trust takes a 99 percent limited partnership interest in the domestic limited partnership and the grantor agrees to manage the partnership in exchange for a one percent general partnership interest.

At the end of the day under the typical international trust, the grantor has given up her assets but has retained control over them in her capacity as the general partner of the limited partnership which now owns those assets. Thus, she retains the right to make day-to-day decisions on investment and management of these assets. Should she run into unexpected legal troubles, the domestic trustees might resign and the foreign trustee could force the dissolution of the limited partnership, moving the assets offshore and out of harm’s way. Until disaster looms, the assets never leave the United States.

Advantages of an International Trust

Although the basic structure of an international trust is fairly simple, its effect is not. By establishing the foreign trust, the grantor makes use of trust law not available domestically. The law of most offshore financial centers is more favorable to the grantor. For instance, in Arizona, creditors of a self-settled trust may reach the grantor’s entire contribution to the trust.⁶ This is not true in many offshore jurisdictions, such as the Cook Islands, where it is possible to self-settle a spend thrift trust.⁷ In addition, many offshore financial centers have shorter periods in which to challenge conveyances into the trust.⁸ Some jurisdictions elevate the burden of proof and make injunctions more problematic for aggrieved creditors.⁹ Finally, as James Ehinger noted, many foreign jurisdictions do not recognize judgments from other courts (including the United States) for any purposes.¹⁰

The primary advantage of an international trust structure is that it puts the grantor in a better negotiating position when unforeseen financial problems develop. An international trust also makes the grantor less of a litigation target, given all of the procedural and substantive impediments to collection. Although an international trust provides a high level of confidentiality concerning the grantor’s financial affairs, the trust’s effectiveness is not based on secrecy. All of the transfers and all of the trust’s business may be disclosed (perhaps even intentionally) to threatening creditors. Finally, because many of the assets remain domestically based, an international trust also leaves the grantor with a great deal of flexibility regarding the investment, control and management of the assets conveyed into the trust.

For those who perceive an international trust as too far out on the asset- protection spectrum, there are less-sophisticated asset protection devices with their own risks and rewards. Holding property in joint tenancy or by tenancy-in-common decreases its attractiveness to creditors.¹¹ Arizona law exempts a number of assets from the claims of creditors (most notably the homestead), and these exemptions are preserved in bankruptcy.¹² Interests in limited partnerships, limited liability companies and other similar entities are problematic collection sources. Under Arizona law, a judgment creditor’s sole remedy is to charge the debtor’s interest in a limited partnership or limited liability company.¹³ The creditor gains no say in the management or operation of the charged entity.¹⁴ After entry of the charging order, any dry income (which can be considerable) is taxed to the creditor.¹⁵ While each of these asset-protection devices has benefits, each has drawbacks as well. Using just a limited partnership subjects the asset solely to the whims and laws of the domestic legal system. For instance, in Evans v. El Dorado Improvement Co., 119 Cal. Rptr. 889 (1975), the court found the limited partnership to be a mere "business conduit" and disregarded it for purposes of execution.

The Typical International Trust Client

Although an international trust may seem too expensive and exotic for all but the most well-heeled clients, this is not the case. There are a host of potential clients of more modest means who could consider such a structure.

For instance, anyone operating in the form of a general partnership should consider the benefits of an international trust. While partnerships have often been formed to hold real estate, they have also been the entity of choice for many law and accounting firms. While the new limited liability and professional association statutes have reduced the use of the partnership form for professionals, it has not eliminated all such partnerships. Those former partners in Laventhal & Horwath, Gaston & Snow and Heron, Burchette, remember the difficulties imposed when one office of a national partnership brings upon the financial collapse of all the partners.

Physicians, surgeons and others at risk to suit for tort liability often use an international trust as a supplement or backstop to malpractice coverage. Oftentimes such clients perceive that high malpractice limits, instead of providing protection, only invite marginal litigation. An international trust allows them to reduce their coverage while maintaining financial security. Similarly, anyone who holds real property in their own name can use a trust to soften the impact of CERCLA liability.

While this list of candidates seems to most obviously benefit from protection of assets, creative practitioners have found several other uses for the international trust. For instance, it is an attractive and unconfrontational alternative to a prenuptial agreement.¹⁶ Anyone selling a business for cash can help shield themselves against buyer’s remorse through the use of such a structure. While the uses of an international trust are more limited for persons who already have financial problems, a business opportunity trust or a payback trust does allow most individuals to protect their future earnings in a non-fraudulent manner.

Given the measurable benefits of these structures, it is perhaps difficult to understand why more people do not take advantage of them. There appear to be at least four primary reasons. First, an international trust is a relatively new device and it is not fully tested in the courts in the United States. Those cases that have been reported concerning an international trust involve seriously flawed planning done at the worst possible time.¹⁷

Second, an international trust, by definition, involves foreign professionals, which makes many clients nervous. Most U.S. clients feel more comfortable placing decisions concerning the disposition of their assets in the hands of domestic trustees and tribunals. Some clients can be reassured if they are informed that the assets may never need to go offshore. If the domestic legal seas become stormy, liquid assets can go to Switzerland, the Bahamas or the Caymans, where wealthy Europeans have kept assets for many years. Even though a trust is settled in, say, Gibraltar, its assets may be domiciled elsewhere.

Third, some clients perceive that the cost to establish and maintain an offshore structure is too great. This perception is largely misplaced. Individuals with more than $500,000 in liquid assets or more than $1 million in net worth serve as good candidates for international trust work. In relationship to the assets protected, the initial and maintenance costs are not significant.

Fourth, some clients believe that the worst will not happen again. They hold firmly to the irrational belief that either the Phoenix market will not suffer another downturn, or that they have overcome their financial difficulties. There is little that can be done to convince a stubborn client on this issue.

Primary Disadvantages and Risks

As with all such planning, there are risks and disadvantages to the international trust. The primary issue of concern to lawyers assisting clients in this area is the law on fraudulent conveyances. There is a very serious and real risk of fraudulent conveyance issues in international trusts both to the lawyer and the client.¹⁸ A practitioner must be very careful to avoid fraudulent conveyances in the establishment and foundation of the trust.¹⁹ The grantor conveys property into the trust and gets a beneficial interest in return. Since what the grantor obtains in return either has no value or highly uncertain value, a conveyance into a typical trust fits the classic definition of a fraudulent conveyance.²⁰ Therefore, international trusts generally must be established at a time when the grantor’s legal difficulties can be accounted for in the planning. Given the personal exposure for the professionals involved, this issue bears very close attention.²¹

There are other risks as well. International trusts have not been fully tested in domestic courts. In addition, the grantor does lose some control over her assets. Finally, the Internal Revenue Service has raised its level of review on foreign trusts, although this risk may be overrated.²²

Conclusion

The question, of course, is does all of this really work? The lawyerly answer is to respond with a question. What do you mean by work? Will an international trust prevent a suit? No. Will it prevent attacks on the structure? Of course not. Will it insulate all assets from the collection actions of creditors? No.

If by work, however, one means, will it increase the likelihood that the client will be able to come through a financial crisis in better shape than if no asset protection work had been done, then the answer is yes. Although there are many different methods and means by which to attack an international trust, generally speaking, the best an adversary can do to a well-planned trust is to battle the grantor to a stalemate. Under such circumstances, creditors will often seek a settlement.

No asset protection strategy is ever truly "bulletproof." The creditor’s bar is much too bright and much too diligent to throw up their hands in defeat. While no asset protection structure may be said to conclusively put property beyond the reach of creditors, an international trust unquestionably raises significant barriers to collection. Those real estate developers in the late ’80s and early ’90s who had previously given no thought to asset protection found that their lack of planning significantly improved their creditors’ collection efforts. Unquestionably, the protection afforded by an international trust would have helped many. The effectiveness of any asset-protection structure depends upon a multitude of factors, including the timing of the efforts to protect the assets and their location. However, in most cases, an international trust offers significant asset protection benefits.

Philip R. Rupprecht is a shareholder in Hebert, Schenk & Johnsen, P.C. His practice emphasizes creditor/debtor relations, asset protection and international trusts.

ENDNOTES:

1. See, Southwest Savings & Loan Association v. Sunamp Systems, Inc., 172 Ariz. 553, 838 P.2d 134 (1992) and A.R.S. § 44-101(9).
2. D’oench, Duhme & Co. V. FDIC, 315 U.S. 447, 62 S. Ct. 676, 86 L. Ed.2d 956 (1942).
3. J. Ehinger, "Pre-Litigation Planning in Multinational Cases," Arizona Attorney, April 1997 at 20.
4. See generally, C. Bruce & S. Gray, "Offshore Protection-of-Asset Trusts," U.S. Taxation of International Operations. ¶ 13,510 (1988); L. Solomon & L. Saret, Asset Protection Strategies, § 6.1 (1993).
5. B. Engel, "Determining Whether A Creditor Can Access Assets In An Offshore Trust," Journal of Asset Protection, Vol. 1, No. 1.
6. A.R.S. § 14-7705.
7. International Trusts Act, 1984 as amended at ¶¶ 13C and 13F.
8. Compare, A.R.S. § 44-1009 (Arizona’s four-year statute) with Fraudulent Dispositions Act, 1991 at ¶ 4(3) (two-year statute in the Bahamas); Offshore Trusts Act, 1992, § 10 (two-year statute in Mauritius); Nevis International Exempt Trust Ordinance, § 24 (two-year statute in Nevis).
9. See, International Trusts Act, 1974 (Cook Islands) as amended at ¶ 13B (fraud must be proven beyond a reasonable doubt) and ¶ 13K (placing procedural hurdles in the way of an injunction to freeze assets).
10. J. Ehinger, supra, at 22.
11. Although a creditor can reach the debtor’s interest in property held jointly, the rights of the other owner makes the property less attractive. Graham v. Allen, 11 Ariz. App. 207, 463, P.2d 102 (1970). While a creditor may elect to seize and sell the debtor’s boat, who is going to buy a one-half interest when the remainder is owned by the debtor’s fishing buddy and it is parked in the buddy’s back yard?
12. A.R.S. §§ 33-1101 to 33-1133. The homestead exemption is set out in §§ 33-1101 to 33-1105. Arizona’s exemption scheme is preserved in bankruptcy under 11 U.S.C. § 522 and A.R.S. § 33-1133(B).
13. A.R.S. § 29-341 and § 29-655.
14. A.R.S. § 29-340 and § 29-732(A).
15. Rev. Rule 77-137.
16. Property not owned by a spouse on the date of marriage cannot be transmuted or commingled. A.R.S. § 25-213; Evans v. Evans, 79 Ariz. 284, 288 P.2d 775 (1955). If the property is owned by an international trust, it will be much harder to transmute or commingle.
17. See, e.g., In re Portnoy, 201 Bankr. 685 (Bankr. S.D.N.Y. 1996); In re Sullivan, 204 Bankr. 919 (Bankr. N.D. Tex. 1997).
18. Even jurisdictions generally favorable to asset protection will, under the right circumstances, act to prevent fraudulent conveyances. 515 South Orange Grove Owners (et al) v. Orange Grove Partners; B. Weenik, "Shutting the Door on Deceit," Shore to Shore, April 1997.
19. L. Solomon & L. Saret, supra at § 6.3.
20. A.R.S. § 44-1004(A)(2); 11 U.S.C. § 548(a).
21. McElhanon v. Hing, 151 Ariz. 403, 728 P.2d 273 (1986).
22. D. Lockwood, "Expert’s Critical Analysis of the Foreign Trust Tax Law Charges and Their Effect on Foreign Asset Protection Trusts," Insights and Strategies, Vol. 10, No. 3. (1997).