9th Circuit Opens Spendthrift Trusts to Bankruptcy Creditors

(CN) – The Ninth Circuit ruled Tuesday that creditors may access trust distributions from spendthrift trusts to pay off bankruptcy debts, minus any funds allocated for education or living expenses.

The ruling clarifies California’s seemingly contradictory laws regarding just how much creditors can access from spendthrift trusts – a trust that is not under the control of the beneficiary and usually protected from creditors.

In 2009, a month before he was due to receive his first payment from a trust left by his parents, Rick Reynolds filed for bankruptcy. Facing $1.7 million in debt to several creditors, Reynolds was entitled to $250,000 on the 30th day after the death of his father and $100,000 a year for 10 years. The trust fund, mostly made up of undeveloped real estate, is estimated to be worth several million dollars once liquidated. Reynolds argued that California Probate Code limited the bankruptcy estate to no more than 25 percent of the trust.

The conflict in California law stems from two different sections, one stating that creditors are due payment once principal is paid to the beneficiary and another stating the maximum a bankruptcy trustee could be paid is 25 percent of the trust’s principal.

The bankruptcy trustee, attorney Todd Frealy, argued the bankruptcy estate was entitled to more under state law, but the bankruptcy court ruled in favor of Reynolds. A bankruptcy appellate panel upheld that decision, prompting Frealy to appeal to the Ninth Circuit.

The Ninth Circuit asked the California Supreme Court to clarify which part of probate law was the correct one to apply. In a ruling this past April, the California high court interpreted the law as not limiting creditors to only a quarter of the trust’s principal.

“We conclude that a bankruptcy trustee, standing as a hypothetical judgment creditor, can reach a beneficiary’s interest in a trust that pays entirely out of principal in two ways,” the court wrote in the ruling. “It may reach up to the full amount of any distributions of principal that are currently due and payable to the beneficiary, unless the trust instrument specifies that those distributions are for the beneficiary‘s support or education and the beneficiary needs those distributions for either purpose.”

With the California court’s answer in hand, the Ninth Circuit panel said Tuesday that normally protected spendthrift trusts are subject to some repayments to creditors in bankruptcy cases.

“Based on the California Supreme Court opinion, we now hold that a bankruptcy estate is entitled to the full amount of spendthrift trust distributions due to be paid as of the petition date,” the per curiam court wrote. “But the estate may not access any portion of that money the beneficiary needs for his support or education, as long as the trust instrument specifies that the funds are for that purpose.”

While the ruling does remove some of the armor of spendthrift trusts, it does not completely subject them to creditors of bankruptcy estates.

Jesse Finlayson, of Finlayson Williams Toffer Roosevelt and Lilly represented Frealy. David Meadows represented Reynolds.

Circuit judges Alex Kozinski and Susan Graber, and U.S. District Judge Charles Breyer, sitting by designation from the Northern District of California, made up the panel.

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