Dodging the litigation explosion.

With the definitions of corporate and personal liability expanding, the time to engage in asset protection planning is now. While not inexpensive, vehicles including foreign and domestic trusts offer shelter from prospective legal actions.

Alan Marsh was chairman and chief executive of Abacon Inc., a publicly held conglomerate with business interests and activities worldwide. He was greatly concerned about his company's financial well-being--and, as a consequence, his own financial health. Alan's worst nightmare came true, starting with a derivative suit that was slapped on the company and its board of directors by a group of shareholders disgruntled with the levels of compensation paid to Abacon's upper management. A few weeks later, Abacon's legal department notified Alan that toxic waste had been discovered on company real estate in southern Pennsylvania.

Naturally, Alan was quite disturbed when he reviewed a legal memorandum prepared by outside counsel covering the personal liability to which Abacon's directors and officers were exposed for response and cleanup costs. At last report, Abacon had sought bankruptcy protection, as had Alan and a number of Abacon's other directors and officers.

Had Alan and his wife engaged in some form of asset protection planning, they likely would have weathered the legal storms far better. Following is a description of domestic and offshore protection instruments we find particularly effective and a look at the legal and personal circumstances under which they seem to work best. Asset protection planning should be done at a time when the client's legal seas are calm--haste may prompt the selection of protection options that may not be most appropriate to one's long-term needs. While protection is not inexpensive--some common types of trusts, for example, cost about $15,000 a year to establish and $2,500 to operate--many clients find the protection to be well worth it.

FAMILY LIMITED PARTNERSHIPS

Family limited partnerships, or FLPs, are a popular tool for protecting accumulated wealth. Assets that would otherwise be attractive to a creditor are rendered unattractive by transferring them to an FLP in exchange for general and limited partners' interests therein. Following transfers to an FLP, the transferor will own the partnership interests rather than the transferred assets. State partnership law generally provides that a creditor's remedy against ownership interests in a limited partnership is to obtain a "charging order," which is typically a rather limited remedy. Moreover, a creditor who successfully obtains a charging order runs the risk of being taxed on the partnership's income, whether or not the creditor receives any distribution from the partnership. The threat of phantom income can discourage a creditor from obtaining a charging order.

FLPs are useful not only in rendering otherwise attractive assets unattractive, but also in separating ownership from control. This is the true benefit of an FLP, particularly when it is coupled with an asset protection trust, or APT. Through an FLP, substantial value can be transferred through assignments of interests as a limited partner at a time when the client's legal seas are calm, with control over and possession of partnership assets retained by the client through his or her interest as a general partner. As discussed below, continued benefit from transferred partnership interests can be enjoyed through the use of an APT.

Despite their apparent advantages, FLPs are not the protection panacea many planners think them to be:

* The client who limits his or her planning to FLPs necessarily remains subject to the whims of the domestic legal system.

* A client will be limited in his or her ability to freely access partnership assets once a charging order is obtained by a creditor.

* Concern exists that a business purpose for the creating and funding of an FLP may be required by a court, and as such, the creditor may not be limited in the exercise of its remedies to obtaining a charging order.

* Independent of the "business purpose" concern is the fact that on the authority of two recent California cases, interests in a limited partnership can indeed be foreclosed upon if it can be done without interfering with the business of the partnership.

While an FLP offers a number of asset protection planning benefits, a person of means who limits his or her planning to an FLP will be compromising both the degree of protection and the number of options that otherwise would be available should a legal problem develop. We maintain that charging order protection and the threat of phantom income are incidental to the true benefit of limited partnerships--that of allowing one to separate ownership from control. This is a particularly useful aspect of limited partnerships when it is employed through the use of a trust.

DOMESTIC TRUSTS

For purposes of this article, references to a "domestic trust" are to a trust settled by a resident of the U.S. pursuant to the laws of one of the several states. Likewise, references to a "foreign trust" are to a trust settled pursuant to the laws of a foreign country.

Choice of law principles allow a person who resides in one state to create a trust to be governed by laws in effect elsewhere, whether in another state or in a foreign country. The principle is the same as that which, for example, allows a New York company to incorporate in Delaware.

While domestic trusts have long been a useful tool in asset and tax planning, in the asset protection planning context, they suffer from a number of disadvantages when compared to foreign trusts:

Limitations on benefit and control. Domestic trust law generally restricts the nature and extent of benefit and/or control that a "settlor," the person who created the trust, can retain through a trust. The law of the properly selected foreign jurisdiction will provide reassurance about the issue of whether benefit and control can be retained.

Automatic target. A domestic trust may be as much a target for litigation as its settlor, particularly if the trust holds assets of substantial value. By its nature, a foreign trust is not such an automatic defendant.

Lack of practical barriers. A foreign trust imposes certain practical barriers that will determine how far a creditor will pursue trust assets. Domestic trusts lack this powerful advantage.

Not as protective. The trust law of some foreign jurisdictions is simply more protective than domestic trust law. Over the past few years, a number of offshore financial centers have passed legislation designed to lend clarity to APT issues, thus providing a substantial degree of certainty to this rapidly developing planning area. These centers are the Bahamas, Belize, the Cayman Islands, the Cook Islands, Cyprus, Gibraltar, and the Turks & Caicos Islands.

While domestic trusts are a valuable planning tool, in terms of asset protection and as discussed above, they tend to offer substantially less protection than foreign situs trusts. They also are not nearly as flexible a planning tool.

FOREIGN SITUS TRUSTS

One of the strategic advantages of APTs is that differences in competing legal systems can be arbitraged to produce superior protection for the trust, its settlor, and beneficiaries. This is an important planning consideration when it comes to matters such as the ability to force the legal battle over trust assets into the foreign court, and the ability to protect the settlor or others who may hold some measure of control against the awkward position of someday being forced to either repatriate trust assets or be held in contempt of court.

These strategies are the foundation of the protection offered by an APT, and support the proposition that the trust instrument itself is only a static part of a dynamic process. It is one thing to draft an APT, and yet another to have a full understanding of the options the APT creates and the manner in which the options may be implemented without the client losing control over his or her destiny. Further, an APT may be rendered relatively useless unless committed, dedicated, and proven team members in the relevant foreign jurisdiction(s) are involved.

COMBINATION STRATEGIES

The optimum protection strategy may involve the combination of APTs and FLPs. As noted earlier, the combination can be achieved merely by one or more gifts to the APT of interests as a limited partner in the FLP. As a result of this combination, value (in the form of interests as a limited partner) can be gifted during a period when the client's legal seas are calm. The client, however, can retain control over the FLP's assets as the general partner of the FLP. Should the client's legal seas become choppy, a number of options are available that would otherwise not exist, including the foreign trustee removing the domestic trustees and forcing a liquidation of the FLP. In such an event, FLP assets would flow to the APT based on the percentage of ownership the APT has in the FLP. Then, in the exercise of the foreign trustee's fiduciary duty to protect assets for and on behalf of the trust beneficiaries, the foreign trustee would likely reinvest and diversify the distributed assets out of the jurisdiction in which the settlor resides, which is the first step in forcing the battle over those assets into the foreign court.

A CLOSING WORD

Having described asset protection planning, I would like to offer a brief word on what it is not. Such planning is not an excuse to defraud creditors.

For the good of the client--as well as a protection planner--an asset protection plan must be implemented within the bounds of propriety, defined by reference to applicable fraudulent transfer law which, in general, prohibits transfers made with the intent to hinder, delay, or defraud persons having a claim against the client or to whom the client owes some form of obligation.

Additionally, it requires no secrecy, nor does it carry any particular tax advantage or disadvantage.

Potential clients and their advisers frequently ask whether this kind of planning "works." Though it may sound trite, I often respond to this question with another question: "If the worst possible business and personal circumstances come to pass, and the legal system comes knocking at your door, would you have been better off with at least some measure of asset protection planning?"

Put in such commonsense terms, this question is not usually all that difficult to answer.

Barry S. Engel is a principal in the law firm of Denver-based Engel & Rudman, which specializes in international law, and tax, business, and estate planning. He is also a member of the international bureau of Offshore Investment magazine, and president of the Isle of Man-based Offshore Institute.