Beware of Rights of Beneficiary’s Divorcing Spouse in Delaware

The high-profile divorce between Kentucky residents Daniel and Beth Kloiber took center stage in 2014 when the Court of Chancery of Delaware released their unpublished jurisdictional decision (the 2014 Delaware Court Decision) in Matter of Daniel Kloiber Dynasty Trust u/a/d December 20, 2002.¹

The court approved a settlement agreement whereby Beth, as a divorced spouse, was able to break up a Delaware dynasty trust to access some of its assets as a part of her divorce.

It is exactly what happened. A recent proposed order refers to appears that this a settlement agreement in Daniel and Beth’s divorce action, noting that the parties agreed to the entry of an order severing the dynasty trust to create a separate trust for the benefit of Beth to be funded with assets of the dynasty trust. The exact dollar amount to be transferred to Beth’s trust isn’t clear.

Busting Through the Trust

Daniel’s father Glenn had established a Delaware dynasty trust for the benefit of Daniel, Daniel’s spouse (defined using a floating spouse definition that she be married to and co-habitating with him to be a beneficiary) and Daniel’s descendants. Glenn gifted approximately $15,000 to the trust in 2002. In 2003, Dan sold 99.45 percent of his Extreme Software, Inc. shares to the trust for an unsecured promissory note with a face amount of $6 million.

In June 2007, the trust sold approximately 80 percent of its Extreme Software, Inc. shares to an unrelated third-party company for approximately $250 million. In March 2008, the trust sold its remaining stock to a different unrelated third-party company for approximately $60 million. So there were big numbers involved, and Beth understandingly wanted a piece of the trust in the divorce.

The biggest issue for the estate planning community was whether Beth’s Garretson v. Garretson argument noted in that opinion would allow her to bust through the trust to claim some of the assets via the divorce. 

Garretson

Delaware has had the Garretson case on its books since 1973. It holds that a Delaware support trust, such as one with health, education, maintenance and support as the distribution standard, is susceptible to being taken by a divorcing spouse.

Specifically, the Supreme Court of Delaware ruled in Garretson that Delaware public policy provides that the rights of a divorcing spouse to access the assets of a spendthrift trust override the rights of a settlor to establish a third-party spendthrift trust for the benefit of the settlor’s intended beneficiaries and protect those trust assets from the divorcing spouses of the trust beneficiaries.

Needless to say, Delaware trust proponents do not like the Garretson case. Since 1973 when the Garretson case was decided, there doesn’t appear to be any case law or statutory law overriding that decision.

2014 Delaware Court Decision 

The court specifically noted in part:

“Second, the Qualified Dispositions Act limits the rights available to creditors of a Trust. Beth has cited Delaware Supreme Court authority holding that a wife seeking maintenance from her husband is not a creditor. See Garretson v. Garretson, 306 A.2d 737, 740 (Del. 1973).

An action brought by a wife seeking separate maintenance from her husband who has deserted her is an attempt on her part to compel the performance of a duty imposed by law upon the husband to support his wife and dependents.

The weight of authority is to the effect that a wife seeking such relief is not a creditor and is not bound by the spendthrift provisions of a trust from reaching the trust assets.

Id. If she is right, then perhaps the Qualified Dispositions Act would not apply.

Third, the Qualified Dispositions Act itself states that the limitations imposed by Section 3572 on a creditor’s ability to reach trust assets do not extend [t]o any person to whom the transferor is indebted on account of an agreement or order of court for the payment of support or alimony in favor of such transferor’s spouse, former spouse or children, or for a division or distribution of property incident to a judicial proceeding with respect to a separation or divorce in favor of such transferor’s spouse or former spouse, but only to the extent of such debt. 12 Del. C. sec. 3573(1).”

This Isn’t Just a Delaware Problem

Although Delaware trusts bear the negative publicity with a settlement like this, as well as by having Garretson on its books, there are many other jurisdictions with spendthrift trusts having the same lack of protection against a divorcing spouse, either by case law saying the spouse isn’t a creditor or by exception creditor statute or case law. The reason Delaware gets highlighted for its lack of protection against divorcing spouses is that it’s widely considered one of the big four dynasty trust states, along with Alaska, Nevada and South Dakota. But practitioners should always consider the law of the trust situs whenever divorcing spouses of the beneficiaries are a concern, even when the trust isn’t sitused in one of the big four states.

Drafting Around the Delaware Problem

Except for the lack of protection from divorcing spouses of the trust beneficiaries, Delaware is otherwise one of the better jurisdictions. However, if you choose to use Delaware law, then you should draft the trust as a discretionary trust rather than a support trust because a discretionary trust doesn’t need to rely on the spendthrift clause to protect the trust assets. A discretionary trust generally uses a bifurcated trustee structure with the primary beneficiary as the investment trustee and a close friend, bank or trust company as the distribution trustee. This isn’t difficult drafting, and in my opinion, it should be the only way to draft a Delaware trust.

But if you prefer to use a trust with health, education, maintenance and support or another support standard for distributions, then very simply you shouldn’t use Delaware or any other jurisdiction that subjects these trusts to divorcing spouses.

Endnote

1. Matter of Daniel Kloiber Dynasty Trust u/a/d December 20, 2002, 2014 WL 3924309 (Del. Chan., unpublished, Aug. 6, 2014).