In the book and movie Harry Potter and the Chamber of Secrets, Dumbledore, the schoolmaster/sage at Hogwarts (the school for the magically gifted) says that we're not judged by the gifts or abilities we are given but by the choices we make. The dramatic appeal of the Harry Potter stories is that we watch him confront challenges created by the villainous Lord Voldemort, make the right decisions and succeed. Goodness wins the day; it's very satisfying.

The pain of reading the business pages these past two years has been seeing how many of our nation's top executives seem to have faced temptation — and failed. One after another, they have (or at least seem to have) betrayed the trust that shareholders and corporations placed in them, apparently protecting their own stakes in company stock and options rather than the collective good. Many have fallen, including Capital One's former chief financial officer, David Willey; Tyco International's former chairman and chief executive officer, Dennis Kozlowski; and Sprint's former CEO, Bill Esrey, and former president, Ron LeMay.

These men might have avoided some legal and ethical problems had they put their personal holdings into a blind asset-protection trust (BAPT) while they were managing company business. The BAPT is an ethical wealth-management solution that any smart business executive should consider. Some companies even encourage their top officers to use them; more should. This is a good-corporate-governance policy.

THE DILEMMA

Executives face special challenges in seeking to have their investment assets (particularly their company stock and options) protected and managed.

Their jobs make their wealth vulnerable to lawsuits; directors' and officers' insurance does not shield them from all claims.

The nature of their compensation is also problematic. Most now receive so much of their pay in company stock and options that it sometimes exceeds their cash compensation and frequently represents a substantial portion of their personal wealth. Such a concentration in one asset class, worse, in just one company, is risky. But securities laws and company policies impede diversification by allowing insiders to sell or otherwise dispose of a company's securities only during open-window periods (usually the limited periods of time following earnings releases).1

And now the wave of corporate scandal has increased government, public, media and shareholder scrutiny of corporate officers' handling of their portfolios.

So, what's an executive to do?

Create a BAPT.

BAPT DEFINED

A BAPT is both a blind trust and an asset-protection trust. Commonly used by government officials to avoid actual and perceived conflicts of interest, blind trusts also are used by business executives.2 In the private sector, blind trusts enable executives to protect, diversify or otherwise manage their stock and/or nonqualified stock-option holdings without being restricted by window periods and without committing insider trading or breaching corporate-fiduciary duty.

There is no universal statutory definition of a blind trust in the private sector. But a blind trust typically involves entrusting by a businessperson of personal-investment assets (such as company stock and/or nonqualified stock options) with an independent (usually corporate) trustee who manages and otherwise disposes of those assets without the insider's participation, influence or knowledge. A distinguishing feature of this kind of trust is its “mutual blindness” (a sort of gag order included in the trust instrument): The insider does not communicate any information about his company to, or attempt to influence the activities of, the independent trustee; in turn, the trustee does not communicate to the insider-settlor, in advance or contemporaneously, any information about his investment decisions or trust activities. As the trustee does not receive any inside information or influence from the executive in administering the blind trust, the trustee's sales or other management of the trust assets (for example, company stock) cannot be based upon material nonpublic information, thereby avoiding insider trading.

Blind trusts offer structuring flexibility. They can be designed to enable businesspeople to pursue customized wealth-management strategies. The instrument typically executes the executive's desired financial-planning strategy, whether it be monetization, immediate diversification (with exchange funds), hedging (for example, with costless collars or prepaid forwards) or gradual (sell-and-reinvest) diversification. Blind trusts also can be designed to implement the executive's asset-protection, tax, philanthropic or wealth-transfer plans. Essentially due to their ethical propriety, blind trusts, properly structured and administered, are well-recognized as offering an affirmative defense to insider trading (under Rule 10b5-1 issued by the Securities and Exchange Commission, as part of regulation Fair Disclosure, under the Securities Exchange Act of 19343) and, as such, also are excepted by the SEC's recent rulemaking from the Sarbanes-Oxley Act's prohibition on insider trades during pension-fund-blackout periods.4

A BAPT also is an asset protection trust. In the United States, asset-protection trusts are popular among executives, physicians, public figures and other professionals exposed to potential liability claims and litigation risk. This is a self-settled spendthrift trust established in accordance with applicable state statutes that is intended to protect assets against creditor claims (subject to certain statutory exceptions and limitations) while giving the settlor the ability to retain an interest therein. Five states — Alaska, Delaware, Missouri, Nevada and Rhode Island — now have laws permitting asset-protection trusts.5

EXAMPLE

How does a BAPT work? Let's look at the case of Mel Praxis, a fictitious highly successful doctor. Mel became chief operating officer of a health-care company three years ago. Before taking on this executive role, he developed and patented a widely used medical-treatment device that continues to generate royalties. While his practice of late has focused on treating certain trusts and estates attorneys afflicted with acute repeal-a-phobia, his invention resulted from his medical treatment of a malady suffered by hedge-fund managers: high correlationitis. Mel discovered that this sickness had resulted from inflammation of the ego leading to the irrationally exuberant belief that one could leap tall buildings with charging bulls or even grizzly bears.

Shortly after Mel joined the health-care company, it went public. He received a lot of stock in the company before and after the IPO. He has sold little of that equity interest and continues to receive more stock as part of his compensation. Though he focuses primarily on his duties for the health-care company, which has expanded internationally, he also occasionally performs a certain medical procedure for which he's renowned; the surgery occasionally takes him to Canada, England and France. Mel is married and has two adult children.

Wanting to protect at least some of his assets, diversify and secure professional investment management, Mel consults you. You develop a plan that includes a BAPT.

You explain to Mel the different options various states provide for asset-protection trusts. Together, you narrow the choice to two: Delaware and Alaska. Mel chooses Delaware because of his international work. He feels more comfortable with Delaware because, as you have explained, Alaska (unlike Delaware) has adopted the Uniform Foreign Money Judgments Act, which requires its state courts to honor foreign judgments.6 Similarly, Mel feels uneasy with the prospect that a claimant possibly could have more opportunity to pierce an Alaska asset-protection trust than a Delaware trust because Alaska has not adopted the Uniform Fraudulent Conveyances Act or the Uniform Fraudulent Transfer Act (the latter of which Delaware has adopted a version of7) limiting the bases on which to prove a fraudulent transfer.

MEL'S DELAWARE BAPT

Accordingly, you create a Delaware BAPT as part of Mel's overall wealth-management plan. To meet the basic requirements of an asset-protection trust under Delaware's Qualified Dispositions in Trust Act,8 you structure the BAPT, among other things, to be irrevocable, contain a spendthrift clause, appoint a Delaware trustee and provide for Delaware law to govern. As Mel desires professional investment management of his trust assets along with professional trust administration, the BAPT appoints a corporate (rather than individual) Delaware trustee of Mel's choosing. Mel is given a special testamentary power of appointment in his BAPT because he wants some control over the ultimate disposition of the trust assets upon his death. You explain that Mel's reservation of this testamentary power of appointment will prevent transfers into his BAPT from being completed gifts and from being excluded from his taxable estate.9 He understands and agrees, because estate-tax exclusion is not one of his objectives in forming the BAPT.

Mel's BAPT is structured as a nongrantor trust for income tax purposes because he wants to save state income tax by utilizing the Delaware tax advantage. Mel, his wife and their two adult children reside in an income-taxing state outside Delaware. But you explain that Delaware does not impose any state tax on the accumulated income or recognized capital gains of an irrevocable non-grantor Delaware trust where the remainder beneficiaries are not Delaware residents.10 Accordingly, Mel agrees that the BAPT be structured so discretionary distributions to him and his wife will require the approval of their older adult child. Both of Mel's adult children also are named beneficiaries in his BAPT. By subjecting such distributions to the direction of an “adverse party,” the BAPT is a nongrantor trust for income tax purposes.11 As a Delaware irrevocable nongrantor trust, the BAPT's income and capital gains will not be subject to Delaware income tax.

Mel's BAPT also is structured as a blind trust to enable him to diversify his restricted stock holdings without being constrained by the open window periods of his health-care company. You and Mel coordinate with his designated blind trustee to develop (prospectively for his BAPT) a tax-sensitive asset-allocation plan tailored to his requirements. This is usually done during the trust-structuring process before the BAPT is created and funded.

Mel wants to give the professional blind trustee discretion to decide how to pursue a gradual diversification strategy in accordance with his customized asset-allocation plan. The trust document is drafted to give the blind trustee discretionary responsibility for deciding the amounts, prices (subject to a floor selling price chosen in advance by Mel) and times of the restricted stock sales, as well as how to reinvest the proceeds from them and create a more diversified portfolio.

The BAPT also requires the trustee to sell the securities in accordance with Rule 144 (under the Securities Act of 1933), a nonexclusive safe harbor permitting the sale of restricted securities or securities owned by persons controlling, controlled by or under common control with the issuer.12 As a blind trust structured in this way, Mel's BAPT is intended to qualify for the affirmative defense to insider trading under Rule 10b5-1(c)(1). The BAPT also is structured to give Mel the flexibility to add assets to his trust, such as more restricted stock and his nonqualified stock options.

MAKING IT KNOWN

Although there is no requirement that the BAPT instrument be filed with the SEC or any other public body, Mel wants to disclose the fact that he has established a blind trust. An experienced executive, Mel understands that the market generally views blind trusts as appropriate, ethical vehicles for wealth- and tax- planning purposes. Typically, an executive's use of a blind trust is not perceived as a bearish signal (because the independent blind trustee, not the insider, makes the trading and other management decisions regarding the insider's assets).13 Mel recognizes that some of his counterparts across corporate America — Yahoo! Inc. cofounder Jerry Yang included — have sent out press releases to disclose the establishment of their blind trusts. Mel, too, plans to issue a press release announcing his BAPT.

Counsel also sees a benefit in this disclosure: It places in the public record evidence of a legitimate wealth-management strategy before any alleged insider-trading problem arises. Such disclosure subsequently may serve as admissible evidence to support the client's motion for dismissal or summary judgment should a securities lawsuit be filed. Things could have turned out very differently for Capital One's Willey, Tyco's Kozlowski and Sprint's Esrey and LeMay had they utilized blind trusts and taken a disclosure approach.

Mel's BAPT is created and initially funded with a significant portion of his restricted stock. During Mel's lifetime, the blind trustee may make discretionary distributions of income and principal to him and his wife subject to the approval of their older adult child as provided in the trust instrument.14 The BAPT benefits Mel by enabling him to: protect a significant portion of his assets; capture more value from those investment assets; deconcentrate his holdings and create a more diversified, less risky portfolio; generate income and provide discretionary liquidity; save state income tax; comply with securities- and insider-trading laws and his corporate fiduciary duties; follow good corporate-governance practice; and avoid reputational damage to himself and his company.

In short, an appropriate BAPT strategy can be designed to meet the complicated challenges facing the executive client who wants the benefits of both asset protection and a blind trust — most notably, in this environment, safeguarding their ethical and legal propriety. If Capital One's Willey, Tyco's Kozlowski and Sprint's Esrey and LeMay had set up blind asset-protection trusts and taken a disclosure approach like Mel, their stories might have a much happier ending.

Endnotes:

  1. The antifraud provisions of the Securities Exchange Act of 1934 and the rules promulgated under it by the U.S. Securities and Exchange Commission (and corresponding state blue-sky laws) prohibit “manipulative and deceptive devices” in the marketplace of securities, including the sale or purchase of a security on the basis of material nonpublic information about that security or the issuer thereof. Federal insider-trading law is based primarily on section 10(b) of the Securities Exchange Act of 1934 and the SEC's corresponding Rule 10b-5. See 15 U.S.C. Section 78j(b); 17 C.F.R. Section 240.10b-5 (2002).

    Judicial decisions interpreting and applying Rule 10b-5 largely have developed federal insider-trading law. Rule 10b5-1, issued by the SEC and effective Oct. 23, 2000, clarifies a standard for insider-trading liability but does not otherwise modify the judicially developed insider-trading law. See “Selective Disclosure and Insider Trading,” SEC Release Nos. 33-7881, 34-43154 Section III.A.1 (Aug. 15, 2000), www.sec.gov/rules/final/33-7881.htm (hereinafter “SEC FD and Insider Trading Release”) (“The rule does not modify or address any other aspect of insider-trading law, which has been established by case law”) and n.134.

  2. For an overview and more detailed discussion of blind trusts in both the private and public sectors, see Edmond M. Ianni, “Fiduciary Firewalls: A Look at Blind Trusts,” 37th Annual Univ. of Miami Philip E. Heckerling Institute on Estate Planning (2003).

  3. 17 C.F.R. Section 240.10b5-1. See generally SEC FD and Insider Trading Release.

  4. The Sarbanes-Oxley Act of 2002 prohibits, as of Jan. 26, 2003, insider trades under certain conditions during retirement-plan blackout periods. See Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (2002) Section 306. However, as part of its rulemaking under the Sarbanes-Oxley Act, the SEC issued final rules (also effective Jan. 26, 2003) exempting, among other things, purchases and sales satisfying the affirmative defense provisions of Rule 10b5-1. See “Final Rule: Insider Trades During Pension Fund Blackout Periods,” SEC Release No. 34-47225 Section II.B.4(d) and new 17 C.F.R. Section 245.101(c)(2) (Jan. 22, 2003), www.sec.gov/rules/final/34-47225.htm

  5. See generally Alaska Stat. Sections 34.40.110 (the centerpiece of Alaska's asset-protection statutes), 13.36.035, 13.36.043, 13.36.310, 13.36.320, 13.36.330, 13.36.390 (2002); Del. Code Ann. tit.12, Section 3570 et seq. (2002); Mo. Rev. Stat. Section 456.080.3 (2001); Nev. Rev. Stat. Section 166.010 et seq. (2002); R.I. Gen. Laws Section 18-9.2-1 et seq. (2002). References to the Delaware Code will be cited hereinafter as “Del. C.” unless otherwise noted.

  6. See Alaska Stat. Section 09.30.100 et seq.

  7. 6 Del. C. Section 1301 et seq.

  8. See 12 Del. C. Section 3570 et seq.

  9. See Treas. Reg. Section 25.2511-2(b), 26 C.F.R Section 25.2511-2(b)(2002); I.R.C. Section 2036(a), 26 U.S.C. Section 2036(a)(2002).

  10. 30 Del. C. Section 1636.

  11. A Delaware asset-protection trust may be structured as a nongrantor trust for income tax purposes according to an IRS private-letter ruling. PLR 200148028 (Aug. 27, 2001), 2001 Tax Notes Today 232-69.

  12. The blind trustee also will file Forms 144 with the SEC in connection with these proposed sales at the appropriate times. As the seller of the securities, the blind trust is the reporting entity for purposes of Rule 144. The seller, the reporting entity on Form 144, represents by signing that form that it “does not know any material adverse information … which has not been publicly disclosed.” This representation is a matter of course for the trustee due to the mandatory blindness of the trust relationship. See generally the Securities Act of 1933, 15 U.S.C. Section 77a et seq. (2002); 17 C.F.R. Section 230.144 (2002) (Rule 144); SEC Form 144 (Notice of Proposed Sale of Securities Pursuant to Rule 144 Under the Securities Act of 1933) at www.sec.gov/about/forms/form144.pdf

  13. See, for example, Allie Buzzell, “Blind Trusts Strengthen Corporate Governance and Avoid Conflicts of Interest,” HR Banker, April 2003, at p. 1; Joan Urdang, “Putting Faith in Blind Trusts,” CFO, April 2003, at p. 21; Laura Smitherman, “Blind Trusts Help Executives Avoid Insider-Trading Questions,” Bloomberg News, Aug. 13, 2001 (noting the use of blind trusts by executives at different companies).

  14. Ever the comprehensive advisor, you also explain to Mel that he should be able to save state income tax on the royalty income that he receives from his patented medical device. With Mel's agreement and after conferring with your Delaware colleagues, you establish a Delaware holding company (DHC) to hold Mel's royalty rights. The income generated from those intangible assets, now held by the DHC, will not be subject to Delaware income tax. 30 Del. C. Section 1902(b).