The Full Faith and Credit Clause

April 13, 2006

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When considering a Delaware or Alaska asset protection trust, you'll need to be aware of the implications of the Full Faith and Credit Clause in the U.S. Constitution. It requires each state to recognize a judgment entered in another state. Thus, as the argument goes, Alaska or Delaware would have to recognize another state's judgment, and thus allow a creditor access to the trust's assets despite the spendthrift clause.

Therefore, a serious question exists as to the effectiveness of the changes Delaware and Alaska made to their trust laws. The question can really be reduced to one word: jurisdiction. If the trustor resides in a different state, a creditor could sue the trustor/beneficiary outside of Alaska and Delaware, in the state in which the trustor resides. The state in which the suit is filed would likely rule that, under its laws, the assets are reachable by the creditor, consistent with the general rule in most states that a spendthrift clause in a self-settled trust is invalid.

The same result might occur where the creditor was able to file suit in its home state, rather than in Delaware or Alaska. Normally, a lawsuit can be filed in the state in which a contract is formed or a tort (e.g., negligent act) is committed.

Unfortunately, to date, there have been no reported cases on this issue involving an asset protection trust in Alaska or Delaware. A few cases, involving tax issues, have produced mixed results and, thus, do not offer firm guidance. The above argument can be extrapolated from these few cases. However, this argument oversimplifies the issues.

Each of these cases turned on its own unique facts and involved other issues. Moreover, if a challenge ended up in federal court, which is likely with this type of conflict-of-laws issue, the federal court would have to decide which state's laws to apply--the law of Alaska or Delaware, or the law of the trustor's or creditor's home state.

Both Alaska and Delaware require that the trustee reside in the state, that some or all of the trust's assets be located there, and that the trust administration and paperwork be located there. Arguably, these requirements were enacted to attract capital into these states. However, a secondary goal was to establish grounds for a court to find that the law of Alaska or Delaware, rather than the trustor's or creditor's home state, should be applied to the trusts.

Both states' statutes also expressly provide that they have jurisdiction over the trusts. Further, the trust document itself also will have a choice of law clause that establishes Alaska or Delaware as the controlling law. While none of these facts can assure a favorable outcome, they do buttress the argument that the law of Alaska or Delaware should control the outcome.

Some states assert jurisdiction over any trust where the beneficiary is a resident of the state. Thus, for example, Connecticut imposes an income tax on a resident's share of income from an out-of-state trust. This provision recently was upheld as valid by the courts. In doing so, the courts have concluded that Connecticut has jurisdiction, because Connecticut law dictates that jurisdiction is not determined by where the trust is set up, but instead by where the beneficiary resides. This conclusion, according to the courts, is justified because the interest in the trust is deemed to be personal property owned by the resident beneficiary.