The flood of personal bankruptcies being filed these days lends added significance to a recent decision by the Ninth Circuit that provides comfort to beneficiaries seeking to protect trust assets.

In February 2009, the U.S. Court of Appeals for the Ninth Circuit held in Gaughan v. Costas that a pre-petition disclaimer was valid and effective because the disclaimer was permitted under applicable state law. In re Costas, 555 F.3d 790 (9th Cir. 2009). The court ruled that federal courts must first look to state law definitions of property to determine whether a disclaimer of an interest in a trust or estate constitutes a fraudulent transfer under the Bankruptcy Code.

In this case, the court’s decision meant that because an Arizona woman had disclaimed her inheritance before filing for personal bankruptcy, her other family members and not her creditors were able to enjoy the money her dad had left for her.


THE CASE

On Oct. 18, 2001, Edward P. Dittlof created the Edward Dittlof Revocable Trust under Arizona Law. Upon his death, the trust was to be distributed to several of his children, including the defendant in this case, Rachelle Costas.

Edward died on Feb. 25, 2002, leaving Rachelle an interest worth at least $34,800. She refused to accept her interest and executed a disclaimer under Arizona law to relinquish her claims to the trust property on Nov. 7, 2002. A month later, Rachelle filed a voluntary petition under Chapter 7 of the Bankruptcy Code.

Maureen Gaughan, the Chapter 7 trustee overseeing Rachelle’s bankruptcy case, sought to avoid Rachelle’s disclaimer as a fraudulent transfer under 11 U.S. Code Section 548.

The Bankruptcy Appellate Panel (BAP) refused to avoid the disclaimer under Section 548, as the BAP previously had rejected application of similar state law disclaimers in Wood v. Bright. 241 B.R. 664 (9th Cir. BAP 1999).

But Maureen, as the Costas trustee, argued that the Bright ruling had been undermined by the Supreme Court’s 1999 decision in Drye v. United States, 528 U.S. 49 (1999).

The Bankruptcy Court in Costas found the cases were distinguishable.

The BAP and the Ninth Circuit affirmed the Bankruptcy Court ruling.

CREDITORS SAY DISCLAIMERS COSTAS

In Costas, the Ninth Circuit held that courts should be guided by the Supreme Court’s ruling in Butner v. United States, which requires federal courts to first determine whether there was a property interest under state law. 440 U.S. 48 (1979). The federal fraudulent conveyance provision of the Bankruptcy Code provides that a trustee may avoid any transfer of an interest of the debtor in property made within two years before the date of the filing of the petition when the transfer involved actual or constructive fraud. 11 U.S.C. Section 548.

The Ninth Circuit recognized that “whether a particular action constitutes a ‘transfer’ is a matter of federal law.” Walker v. First Security Bank of Idaho, N.A., 77 F.3d 322, 323 (9th Cir. 1996). But the court also ruled that a transfer can exist under federal law only if there is an interest in property. Quoting Butner, the Costas court reasoned that, while “[t]he Code does not define ‘property’ or ‘an interest in property,’ ‘Congress has generally left the determination of property rights in the assets of a bankrupt’s estate to state law.’”

As a result, only if a property interest exists under state law can courts determine if a disclaimer constitutes a fraudulent transfer under federal law. Indeed, the court found, “Most courts . . . have held that state fraudulent transfer rules do not reach disclaimers that relate back.”

The Costas trustee did not dispute that Arizona law allows beneficiaries to renounce their interests in trusts through disclaimers. The Arizona statute, as revised in 2005, is based on the Uniform Disclaimer of Property Interest Act, which defines a disclaimer as “the refusal to accept an interest in or power over property.” Ariz. Rev. Stat. Section 14-2801(B),(C).

The trustee also conceded the validity of Costas’ disclaimer under Arizona law. Costas, 346 B.R. at 200.

The trustee instead argued that the disclaimer, while valid under Arizona law, nonetheless qualified as a fraudulent transfer under the Supreme Court’s ruling in Drye.

TAX LIENS ARE DRYE READING

In Drye, the high court held that the a disclaimer of an interest in an estate made a month before a bankruptcy filing constituted a fraudulent transfer intended to avoid federal tax obligations. In Costas, the Ninth Circuit found that “Drye is distinguishable, both factually and legally, and that its adoption in bankruptcy context would . . . be inappropriate.”

Factually, the Ninth Circuit reasoned that Drye was distinguishable on timing issues. The disclaimer in Costas occurred pre-bankruptcy petition, while “the situation in Drye is more analogous to a post-petition disclaimer.” In Drye, while the disclaimer occurred pre-petition, a tax lien already was in place before the disclaimer was executed.

The Ninth Circuit found that Drye is limited to tax-lien issues, and that the Supreme Court “repeatedly stressed” this finding in its opinion. And, the Ninth Circuit noted, “[t]ax-lien rules do not translate directly into bankruptcy rules” because collection is the primary focus in tax lien cases.
The Ninth Circuit therefore instead applied the principles of Butner and held that the disclaimer, properly executed under Arizona state law, was not a “transfer . . . of an interest of the debtor in property” for purposes of Section 548.

THE LESSON

State law determines whether interests avoided through pre-petition disclaimers constitute “property” that would be subject to a Section 548 determination under federal law. If state law permits beneficiaries to reject their interest in trusts or estates through disclaimers, and the disclaimer is valid under state law, there is no “property” for the purposes of Section 548. Federal law may determine whether a particular disclaimer constitutes a fraudulent transfer only when states do not permit such disclaimers, or when a disclaimer was not properly executed under applicable state law.

In other words, if a client anticipates having to file for bankruptcy and wishes to benefit his fellow beneficiaries or descendants (depending on the governing document), a disclaimer validly executed under state law remains a viable option.

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