Frealy v. Reynolds: California Supreme Court Strikes Blow at Spendthrift Trusts

On March 9, 2015, in Frealy v. Reynolds, 779 F.3d 1028 (9th Cir. 2015), the Court of Appeals for the Ninth Circuit issued an order certifying the following question to the California Supreme Court: “[d]oes section 15306.5 of the California Probate Code impose an absolute cap of 25 percent on a bankruptcy estate’s access to a beneficiary’s interest in a spendthrift trust that consists entirely of payments from principal, or may the bankruptcy estate reach more than 25 percent under other sections of the Probate Code?” Such other sections would include Probate Code sections 15301(b) and 15307. Click here to read the published order: http://bit.ly/1BjJQoK.

The California Supreme Court recently responded and held that, under California law, a judgment creditor or a chapter 7 trustee can seize all principal of a spendthrift trust that is currently due and payable by the trustee of a spendthrift trust to a beneficiary and 25% of the principal payments that are expected to be made in the future, except to the extent those payments are necessary for the beneficiary’s education or support. Carmack v. Reynolds, __ P.3d __, 2017 WL 1090497 (Mar. 23, 2017). To read the full published order of the California Supreme Court, click here: http://bit.ly/2mYDhVd.

Rick Reynolds was a beneficiary of a family trust established by his parents, which contained the following spendthrift provision: “No interest in the income or principal of any trust created under this instrument shall be voluntarily or involuntarily anticipated, assigned, encumbered, or subjected to [a] creditor’s claim or legal process before actual receipt by the beneficiary.” Frealy, 779 F.3d at 1031. A distinctive feature of the trust, as opposed to a typical trust, was that all disbursements were to be made from principal since the trust assets consisted of non-income-producing undeveloped land. Approximately one month after his father’s death in 2009, Reynolds became entitled to collect $250,000, as well as $100,000 per year for ten years, and one-third of the residue from a sub-trust thereafter.

Reynolds filed a chapter 7 bankruptcy petition one day after his father died. Thereafter, the trustee of the trust commenced an adversary proceeding asking the bankruptcy court to determine the extent of the bankruptcy trustee’s interest in the trust. The bankruptcy court held that under California Probate Code section 15306.5, the bankruptcy trustee, standing as a hypothetical lien creditor, could reach a maximum of 25 percent of Reynolds’ interest in the spendthrift trust. The Ninth Circuit Bankruptcy Appellate Panel (“BAP”), in a divided opinion, affirmed. The chapter 7 trustee appealed to the Ninth Circuit, arguing that the estate was entitled to more than 25 percent because: (1) section 15301(b) of the Probate Code gives creditors unrestricted access to distributions of principal which are “due and payable,” and all of Reynolds’ distributions from the trust were expected to be made from principal; or, alternatively, (2) section 15307 allows the bankruptcy estate to reach any amount of Reynolds’ trust interest not deemed necessary for his education and support.

The Ninth Circuit could find no way to harmonize section 15306.5 with sections 15301(b) and 15307, so it asked the California Supreme Court to clarify whether Probate Code section 15306.5 caps a bankruptcy estate’s interest in a spendthrift trust at 25% of the debtor’s interest, be it principal or income of the trust, or whether the bankruptcy estate is entitled to all funds that are now or may in the future become due and payable to the beneficiary. The California Supreme Court granted the Ninth Circuit’s request.

The California Supreme Court held 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. It may demand payment 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. Furthermore, a bankruptcy trustee can obtain a current order requiring the trustee of the trust to remit up to 25% of any future payments of principal made to, or for the benefit of, the beneficiary, reduced to the extent necessary by the support needs of the beneficiary and any dependents. And if creditors of the estate are not paid in full through these orders, the bankruptcy trustee has the right to obtain subsequent orders, as additional principal becomes due and payable to the beneficiary, that the trustee of the trust remit to the bankruptcy trustee the remaining 75% of any future distributions of principal until all claims are paid in full.

The court began its analysis with Probate Code section 15301(b). Whereas section 15301(a) states that principal held in a spendthrift trust may not be touched by creditors until it is paid to the beneficiary, section 15301(b) provides that after an amount of principal has become due and payable to the beneficiary, upon petition to the court under California Civil Procedure Code section 709.010 by a judgment creditor, the court may make an order directing the trustee of the trust to satisfy the judgment out of that principal amount, except to the extent the distribution is intended for the beneficiary’s support or education and is actually needed by the beneficiary for such purposes. The court defined “due and payable” to mean only “those amounts which are presently set to be paid to the beneficiary” (i.e, those sums that have become due), but not any sums the beneficiary will have the right to receive in the future. Carmack, 2017 WL 1090497 at *3. Therefore, “spendthrift protections do not apply to distributions of principal that have become due and payable.” Id. at *5-6.

The court then turned to sections 15306.5(b) and 15307. Section 15306.5(b) states that any order for payment to a judgment creditor is limited to 25% of the payment that “otherwise would be made” to the beneficiary. But section 15307 states that any amount to which the beneficiary is entitled in excess of the amount necessary for his/her education and support may be applied to satisfaction of the money judgment. The court analyzed the legislative history and concluded that section 15307 “reflects a drafting error,” since the legislature “plainly intended general creditors to be limited to 25 percent of distributions from the trust.” Id. at *5.

Next, the court reconciled its conclusion that a judgment creditor can obtain an order requiring payment of the full amount of a principal distribution that is currently “due and payable” with its conclusion that payments to a creditor are limited to 25% of any payment that “otherwise would be made” to the creditor by holding that the 25% restriction applies only to future payments of principal that will become payable to the beneficiary.

Finally, by way of example, the court stated that if a judgment creditor is not paid in full through these orders, then as future distributions of principal become due and payable to the beneficiary, the creditor can obtain an order for payment of the remaining 75% of each principal distribution until the creditor is paid in full.

The fact that the trust in this case provided the beneficiary with no distributions of income necessarily limited the California Supreme Court’s decision, so we can only speculate what its ruling might have been had the trust included distributions of income. Probate Code section 15300 states that except as provided elsewhere (e.g., in sections 15306.5 and 15307), if the trust “provides that a beneficiary’s interest in income is not subject to voluntary or involuntary transfer, the beneficiary’s interest in income under the trust may not be transferred and is not subject to enforcement of a money judgment until paid to the beneficiary." Cal. Prob. Code § 15300 (emphasis added). And, the 25% restriction of Probate Code section 15306.5 expressly applies to all distributions of principal or interest to a beneficiary. However, the California Supreme Court declined to opine whether distributions of income that are currently due and payable are similarly fully exposed to the claims of judgment creditors and whether future distributions of income are similarly subject to the 25% restriction that exists for distributions of principal. It is this author’s opinion that if that issue comes before the California Supreme Court, the court will reach the same conclusions it reached vis-à-vis current and future distributions of principal from a trust.

Editorial contributions were provided by Robert G. Harris, also of Binder Malter Harris & Rome-Banks LLP. This is a reprint of the State Bar of California Business Law Section Insolvency Law e-Bulletin from April 10, 2017.