property bankruptcy trusts-and-estates
How is property in trustees&#39; hands safe from the trustee&#39;s own creditors?
<p>In the context of <a href="https://en.wikipedia.org/wiki/Trust_law" rel="nofollow noreferrer">trust law</a>, <em>trustees</em> are the legal owners of the property in trust. They hold it for the beneficiaries, who are the equitable owners.</p>

<p>Even though trustees legally own the property, what they can do with it is limited because they owe a fiduciary duty to the beneficiaries.</p>

<p>However, should the trustees become insolvent/bankrupt, how is the trust property protected from their creditors (for transactions not related to the trust)? If they owe lots of money to creditors and they are the legal owners of the property, why cannot the creditors grab the property? Does the fact that the equitable title belong to somebody else protect the property from creditors in any way?</p>

<p>I am seeking answers for any English-centric jurisdiction.</p>

<p>The controlling statute in the United States Bankruptcy Code is <a href="https://www.law.cornell.edu/uscode/text/11/541" rel="nofollow noreferrer">11 U.S.C. § 541(d)</a> which states:</p>

<blockquote>
  <p><strong>Property in which the debtor holds, as of the commencement of the case, only legal title and not an equitable interest</strong>, such as a
  mortgage secured by real property, or an interest in such a mortgage,
  sold by the debtor but as to which the debtor retains legal title to
  service or supervise the servicing of such mortgage or interest,
  <strong>becomes property of the [bankruptcy] estate under subsection (a)(1) or (2) of this section only to the extent of the debtor’s legal title to such
  property, but not to the extent of any equitable interest in such
  property that the debtor does not hold.</strong></p>
</blockquote>

<p>For the purposes of a trustee of a typical trust, only the language in bold is relevant (strictly speaking, this is not an exemption from creditors, which would be found at <a href="https://www.law.cornell.edu/uscode/text/11/522" rel="nofollow noreferrer">11 U.S.C. § 522</a>, but a part of the definition of what a debtor owns).</p>

<p>Only property that is part of the bankruptcy estate is subject to distribution to creditors of the bankrupt.</p>

<p>(The language in not in bold pertains to the special case of mortgages sold in the secondary market to new lenders in which the originator of the mortgage remains the nominee owner, which is economically important in financial company bankruptcies, but not a situation the average person would encounter very often.)</p>

<p>In general, under non-bankruptcy law, creditors of a trustee may not acquire an interest in property greater than that of the debtor (unless a statute such as the <a href="https://en.wikipedia.org/wiki/Holder_in_due_course" rel="nofollow noreferrer">holder in due course rule</a>, <em>see, e.g.,</em> § 4-3-302, Colorado Revised Statutes, provides otherwise), so the same rule applies outside of bankruptcy. <em>See, e.g., <a href="https://supreme.justia.com/cases/federal/us/96/467/" rel="nofollow noreferrer">Casey v. Cavaroc</a></em>, 96 U.S. 467, 473–74 (1877).</p>

<p>Indeed, this subtle rule of law governing the creditors of a trustee was actually the earliest form of limited liability in common law jurisdiction and was used as a model for subsequently devised limited liability entities such a corporations, as <a href="https://columbialawreview.org/content/the-common-law-corporation-the-power-of-the-trust-in-anglo-american-business-history/" rel="nofollow noreferrer">explained by John Morley in the Columbia Law Review</a> (open access). He explains:</p>

<blockquote>
  <p>If a trustee went bankrupt, his creditors could seize the property he
  owned personally for his own benefit but not the property he held as
  trustee in trust for others.43  The creditors could take the trustee’s
  personal farm, for instance, but not the farm he held in trust for the
  beneficiaries. As Professors Henry Hansmann and Ugo Mattei have shown,
  this was an extraordinary innovation because it limited the rights of
  a trustee’s creditors even if the creditors had not personally agreed
  to the limitations.44 This rule emerged gradually over time, but its
  essential contours were in place by the mid-1400s.45</p>
  
  <p>43 Henry Hansmann &amp; Ugo Mattei, The Functions of Trust Law: A
  Comparative Legal and Economic Analysis, 73 N.Y.U. L. Rev. 434, 454–56
  (1998).</p>
  
  <p>44 <em>See id.</em></p>
  
  <p>45 At first, the rule probably operated indirectly. Today, an
  unsecured creditor can seize any property—real or personal—of a debtor
  as long as the property is not already committed to a security
  interest. <em>Cf.</em> Edward M. Iacobucci &amp; George G. Triantis, Economic and
  Legal Boundaries of Firms, 93 Va. L. Rev. 515 (2007) (noting the legal
  implications of how a firm is structured and arguing that a creditor
  of an entity has a formal right to any of that entity’s property). In
  late medieval and early modern times, however, a creditor generally
  could not take land (as distinct from personal property) unless the
  owner had specifically given the creditor a security interest in it.
  <em>See</em> Claire Priest, Creating an American Property Law: Alienability and
  Its Limits in American History, 120 Harv. L. Rev. 385, 401–07 (2006)
  (describing limits on the alienability of land in late-medieval
  English law). Thus, there was no need for a rule in early trust law
  that protected real property from a trustee’s unsecured creditors.
  Since no one could take real property from a trustee unless the
  trustee specifically pledged it, there was no point in cutting off the
  claims of creditors who had no pledge. It was enough simply to have a
  rule that protected property from the secured creditors who had
  received the pledges. This rule was already implicit in the remedies
  against a trustee’s transferees and pledgees that the Chancery began
  enforcing in the mid-1400s. <em>See supra</em> notes 40–41 and accompanying
  text (discussing the use of specific performance and property recovery
  as remedies). In any case, Lord Chancellor Nottingham began fully
  protecting all forms of trust property from a trustee’s unsecured
  creditors in the late seventeenth century. <em>See, e.g., Bennet v.
  Davis</em> (1725) 24 Eng. Rep. 746 (Ch) 746–47; 2 P. Wms. 316, 316–19;
  <em>Finch v. Earl of Winchelsea</em> (1715) 24 Eng. Rep. 387 (Ch) 387–90; 1 P. Wms. 277, 277–83; <em>Burgh v. Francis</em> (1673) 36 Eng. Rep. 971 (Ch)
  971; 3 Swanst. 550, 550; <em>Turner, supra</em> note 38, at 46–48.</p>
</blockquote>

<p>N.B. Professor Henry Hansmann's book "The Ownership of Enterprise", while hard to find, is probably the most insightful book ever written on why different forms of organizations (especially cooperatives v. nonprofits v. investor owner firms) are used in different circumstances.</p>

<p><strong>tl;dr</strong>: a debtor who has "bare legal title" in property may be able to have that property exempted from a bankruptcy estate and its ensuing distribution.</p>

<p><strong>Background</strong></p>

<p>A debtor's bankruptcy estate consists of "all legal or equitable interests of the debtor in property, both real and personal, at the time of the bankruptcy filing."  The automatic stay of <a href="https://www.law.cornell.edu/uscode/text/11/362" rel="nofollow noreferrer">11 U.S.C. § 362</a> prevents creditors from taking control of the assets until the court decides on a distribution.</p>

<p>One of the key steps in finalizing a distribution is deciding what property is actually a part of the estate. To minimize their losses, creditors generally want the estate to be as large as possible. The debtor usually wants the estate to be as small as possible. To determine what property is included, the court often relies on the distinction between exempt vs. nonexempt property. Exempt property is that which a debtor may retain "free from the claims of creditors who do not have liens."</p>

<p>One of the mechanisms for exempting property relies on a common law concept called "bare legal title." Property law distinguishes between types of ownership by separating title into legal and equitable components. Legal title gives the holder the ability to transfer it, while equitable title refers to a person's right to obtain full ownership (even while another maintains legal title). For example, if E owns some piece of property outright but decides to let L manage it as E's fiduciary, it's common for E to retain equitable title while L holds the legal title.</p>

<p>Were L to become a bankruptcy debtor, the court would likely (initially) include E's property in the bankruptcy estate because L has legal title. However, because L lacks equitable title and is managing E's property as a fiduciary, there's likely a "bare legal title" argument that should be made to exempt this particular property from L's bankruptcy estate.</p>

<p>Determining whether bare legal title is the right categorization depends on the facts of the case. However the principle is well enshrined in U.S. law. See generally, for example, <em>Drye v. United States</em>, 528 U.S. 49 (1999); <em>State Bank of Hardinsburg v. Brown</em>, 317 U.S. 135 (1942).</p>

<p>What helps to determine whether a debtor has bare legal title? Controlling the property for one's own benefit, maintaining it, paying for it—all of these are things equitable owners usually do. So if the debtor takes on these benefits and responsibilities, the court might determine that the debtor has both legal and equitable title and include the property in the bankruptcy estate.</p>

<p><a href="/questions/tagged/united-states" class="post-tag" title="show questions tagged &#39;united-states&#39;" rel="tag">united-states</a></p>

<p>English Law Answer:</p>
<p>Trustees do not have beneficial ownership over any trust property, despite them having legal ownership. Therefore any debt claims against them <strong>cannot</strong> be enforced against trust property that they merely control.</p>
<p>What this means, is that if you sue someone, and he happens to be a trustee over someone else's property, then you cannot touch that property. <strong>That property is not his, it is the beneficiaries'.</strong></p>
<p>I am quite surprised at the lengths of the American Law answers. In English law the position is straightforward. If a man goes bankrupt, he cannot use money that he manages on trust to pay his debts, after all, the money is not his.</p>
<p>Laymen may ask the question: What if the money is in his bank account? How do you separate money belonging to a trust vs his own money?</p>
<p>Answer: <a href="https://en.wikipedia.org/wiki/Tracing_in_English_law" rel="nofollow noreferrer">The common law rules on tracing</a> would apply. Tracing is the method used to identify property held in trust when a wrongdoer takes the money and converts it into another form (e.g mixing it with his bank account, or using it to buy property). In contract, there may be a good reason why money is held on trust but mixed with someone else's money. For example, where a father who has 1 million pounds in his bank account declares that half of it is to be held on trust for his children. Suddenly the money needs to be separated.</p>
<p>The rules can get very complicated</p>
<p>Another question may be: Does this mean that people going bankrupt can just put property on trust to avoid losing the property?</p>
<p>Well an excellent answer taken from the <a href="https://www.thepfs.org/learning-index/articles/trusts-and-attempts-to-avoid-creditors/50518" rel="nofollow noreferrer">Chartered Insurance Institute</a> is reproduced below:</p>
<blockquote>
<p><em>Trusts and protection from creditors</em></p>
<p>It is well known that, for a trust to be legally effective, the settlor must divest himself of the beneficial ownership of the trust property. This is especially important where the settlor is one of the trust beneficiaries or has reserved extensive powers for himself. If the trustees do not assume proper control over the trust property and simply follow the settlor’s instructions, the chances are the trust will be declared to be a sham or a mere illusion (there is only a subtle difference in law between the two). There have been a number of cases where a trust has been declared to be a sham and therefore not valid.</p>
<p>As for trying to avoid creditors, even if a trust is not a sham, there is no absolute protection.  Namely, there will be no protection for trust assets if at the time of making the transfer to the trust the settlor is already insolvent (or becomes insolvent as a consequence of the transfer) or the transfer is made with a view to avoiding creditors. The statutory basis for this in England and Wales is in sections 339-423 of the Insolvency Act 1986.</p>
<p>Generally, transfers made more than 5 years before insolvency will be &quot;safe&quot; but there is no time limit if the intention was to defraud creditors.</p>
</blockquote>
<p>The answer mentions &quot;sham trusts&quot;. One of the requirements for a trust is that it is not a sham. A court may interpret that a trust is used for an illegitimate purpose such as avoiding creditors, and may therefore rule that the trust is a sham and does not exist.</p>
