Altered Egos – Part 2: Trust Busters

Altered Egos – Part 2: Trust Busters

About a month ago, the Ninth Circuit clarified and restated the ability of individual creditors to pursue claims against debtors based on an alter ego theory, despite a bankruptcy trustee’s efforts to reach the same assets (discussion here).

Last week, the Ninth Circuit further expanded the reach of alter ego liability to “asset protection” trusts established by debtors.  Along the way, and in dicta, it finessed earlier treatment of the same liability in the corporate context.

U.S. Court of Appeals for the Ninth Circuit
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The facts in In re Schwarzkopf are somewhat involved, but essentially reduce themselves to the following:  During the 1990’s, the debtors established two separate and allegedly irrevocable trusts – the “Apartment Trust” (to hold the debtors’ stock in a corporation which owned and operated an apartment building) and the “Grove Trust” (to hold four plots of land containing avocado groves).  The Apartment Trust was established to remove the debtors’ stock from the reach of creditors while the debtors contested a judgment obtained against the corporation.  The Grove Trust was subsequently established while the debtors were insolvent – and, likewise, was intended to move the debtors’ assets beyond the reach of their creditors.

During the life of both trusts, the debtors routinely sought and obtained use of the trust assets for their personal benefit and for the benefit of family members.  The trustee administering the trusts apparently exercised no independent judgment regarding the debtors’ requests, commingled trust assets, and kept no books and records regarding either trust for several years after their establishment.

The debtors filed a Chapter 7 case in 2003, seeking to discharge approximately $5.4 million in debt.  The appointed Chapter 7 trustee filed an adversary complaint seeking to recover approximately $4 million from the trusts.  The bankruptcy court initially concluded both trusts were valid and that neither is the alter ego of the debtors, but subsequently reversed the alter ego determination as to the Grove Trust.

The District Court found that the trusts were not the debtors’ alter ego, reasoning that under SEC v. Hickey, 322 F.3d 1123 (9th Cir. 2003), legal ownership is a prerequisite for such liability in California.  It also found the Apartment Trust was not valid, but remanded so the Bankruptcy Court could determine whether or not the Trustee’s complaint was time-barred in the first instance.

The Ninth Circuit quickly dispensed with the Apartment Trust, finding the statute of limitations for attacking the Apartment Trust did not begin to run until the trustee answered the avoidance complaint filed in the debtors’ Chapter 7 cases.

It then turned to the Grove Trust, finding that despite its continuing existence as a trust, it was the nevertheless the debtors’ alter ego.  To reach this conclusion, it reasoned that despite its earlier decision in Hickey, which had concluded that actual ownership of stock was a prerequisite for alter ego liability in corporate cases, California law nevertheless suggested that equitable stock ownership was sufficient for alter ego liability after all . . . and that, in any event, an equitable ownership interest is “traditionally sufficient to confer ownership rights” in the trust context.

Schwarzkopf‘s facts certainly suggest the Ninth Circuit was reaching to assist the trustee’s efforts to recover significant assets for the benefit of creditors.  However, its relaxed treatment of the “ownership threshold” for alter ego liability may prove useful for trustees or creditors in other contexts.

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