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In the context of trust law, trustees are the legal owners of the property in trust. They hold it for the beneficiaries, who are the equitable owners.

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

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?

I am seeking answers for any English-centric jurisdiction.

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    As to the U.S., the automatic stay of 11 U.S.C. § 362 is the mechanism that prevents a creditor food fight. – Pat W. May 22 '19 at 10:53
  • @PatW. A stay will only make it harder for creditors to take the property vs prevent it, right? – Greendrake May 22 '19 at 20:56
  • Greendrake, the stay essentially freezes the ownership until the court can determine the distribution or restructuring. – Pat W. May 23 '19 at 23:16
  • @PatW well, a court decision will be needed for creditors to get their hands on the property anyway, so the stay is of no value. The question is whether courts normally award trust property to trustees' personal creditors not related to the trust. – Greendrake May 23 '19 at 23:43
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    @PatW. Now that is something. I dunno how legal without equitable titles work. If you elaborate that might be a good answer. – Greendrake May 24 '19 at 12:37
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+50

tl;dr: 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.

Background

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 11 U.S.C. § 362 prevents creditors from taking control of the assets until the court decides on a distribution.

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."

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.

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.

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, Drye v. United States, 528 U.S. 49 (1999); State Bank of Hardinsburg v. Brown, 317 U.S. 135 (1942).

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.

  • 11 USC § 362 is actually derivative of 11 USC § 541. The latter defines what is and is not part of the bankruptcy estate, the former establishes that the property of the estate is protected by the automatic stay (which is temporary in many cases). – ohwilleke May 25 '19 at 22:21
  • @ohwilleke, one might say everything in U.S. bankruptcy flows from § 541. That said, § 362 responds to the post's ancillary question about what prevents a "grab." Section 541 is still subject to the fact finder's determination about whether equitable title obtains. In many ways subsection (d) codifies the common law notion of bare legal title, which courts nevertheless rely upon frequently. – Pat W. May 25 '19 at 22:59
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The controlling statute in the United States Bankruptcy Code is 11 U.S.C. § 541(d) which states:

Property in which the debtor holds, as of the commencement of the case, only legal title and not an equitable interest, 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, 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.

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 11 U.S.C. § 522, but a part of the definition of what a debtor owns).

Only property that is part of the bankruptcy estate is subject to distribution to creditors of the bankrupt.

(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.)

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 holder in due course rule, see, e.g., § 4-3-302, Colorado Revised Statutes, provides otherwise), so the same rule applies outside of bankruptcy. See, e.g., Casey v. Cavaroc, 96 U.S. 467, 473–74 (1877).

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 explained by John Morley in the Columbia Law Review (open access). He explains:

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

43 Henry Hansmann & Ugo Mattei, The Functions of Trust Law: A Comparative Legal and Economic Analysis, 73 N.Y.U. L. Rev. 434, 454–56 (1998).

44 See id.

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. Cf. Edward M. Iacobucci & 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. See 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. See supra 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. See, e.g., Bennet v. Davis (1725) 24 Eng. Rep. 746 (Ch) 746–47; 2 P. Wms. 316, 316–19; Finch v. Earl of Winchelsea (1715) 24 Eng. Rep. 387 (Ch) 387–90; 1 P. Wms. 277, 277–83; Burgh v. Francis (1673) 36 Eng. Rep. 971 (Ch) 971; 3 Swanst. 550, 550; Turner, supra note 38, at 46–48.

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.

  • "The estate referred to in this case is the bankruptcy estate" The bankruptcy in this question refers to that of the trustees' in their personal capacity not related to the trust whatsoever. Say Bob keeps his house in Rob's name for Bob's children. Rob also runs his own business not related to this. The business fails and Rob's creditors come after the house he holds for Bob's kids. Does your answer still apply? – Greendrake May 25 '19 at 22:20
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    @Greendrake The situation you describe is precisely the situation that is covered by § 541(d). If the trustee files for bankruptcy, creditors have only a claim to the extent of the trustee's personal interest (e.g. Rob's right to compensation earned by him and not paid, and reimbursements for expenses advanced by him but not paid) and not to equitable interests in the trust that do not belong to the trustee (e.g. the beneficial use of a house held in trust for Bob's children). I've edited the language of the answer slightly to clarify. Fun fact: probate estates can't file for bankruptcy. – ohwilleke May 25 '19 at 23:09
  • @ohwilleke "The Organization of Enterprise" is so hard to find, I can't find it on his CV, or in the Yale library. Maybe you mean "The Ownership of Enterprise"? – Just a guy Nov 12 '19 at 5:40
  • @Justaguy You are absolutely right. Made bad in remembering the title wrong. "The Ownership of Enterprise" (which I have a hard copy of) is the the best and seminal work on the topic. – ohwilleke Nov 13 '19 at 19:33
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    @ohwilleke You'll be glad to know the book is still in print -- there's even a Kindle edition! – Just a guy Nov 14 '19 at 0:26
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English Law Answer:

Trustees do not have beneficial ownership over any trust property, despite them having legal ownership. Therefore any debt claims against them cannot be enforced against trust property that they merely control.

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. That property is not his, it is the beneficiaries'.

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.

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?

Answer: The common law rules on tracing 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.

The rules can get very complicated

Another question may be: Does this mean that people going bankrupt can just put property on trust to avoid losing the property?

Well an excellent answer taken from the Chartered Insurance Institute is reproduced below:

Trusts and protection from creditors

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.

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.

Generally, transfers made more than 5 years before insolvency will be "safe" but there is no time limit if the intention was to defraud creditors.

The answer mentions "sham trusts". 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.

  • "property that they merely control" This is the crux of the question. How does full legal ownership fade into "mere control"? What law doctrine exactly makes "beneficial ownership" such a thing that, where it is present, bare "legal ownership" no longer can be relied upon? The whole concept of "beneficial ownership" seems to go against the property law under which legal ownership gives the holder ultimate rights. – Greendrake Jun 1 '19 at 0:06
  • The "doctrine in place" is called equity. In most cases, there is only one type of ownership, called true ownership or possession. This is where you have the right to use property in whatever way you want. – Shazamo Morebucks Jun 1 '19 at 9:25
  • However, in trust law (which is part of equity). If someone puts a piece of property "in trust", they have divided the absolute ownership of that property into two types: legal ownership and beneficial ownership. – Shazamo Morebucks Jun 1 '19 at 9:27
  • Legal ownership is the right to do something with property, in the case of trusts law it's almost always ONLY the right invest the property, or if its a piece of land/housing, the right to rent the property out in order to generate an income – Shazamo Morebucks Jun 1 '19 at 9:28
  • Beneficial ownership is the right to benefit from the property, which means, if someone uses their legal ownership over trust money to invest it, and it grows, the beneficiaries with their beneficial ownership are the people who gain the income from those investments. The trustees, lacking beneficial ownership, may not derive any income or benefit from the trust property to themselves – Shazamo Morebucks Jun 1 '19 at 9:30
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Each jurisdiction will have it's own rules, obviously, but in Illinois, whoever established the trust is able to assign powers and duties to the trustee.

Sec. 3. Applicability. (1) A person establishing a trust may specify in the instrument the rights, powers, duties, limitations and immunities applicable to the trustee, beneficiary and others and those provisions where not otherwise contrary to law shall control, notwithstanding this Act. The provisions of this Act apply to the trust to the extent that they are not inconsistent with the provisions of the instrument.

Therefore, you could set the trust up in a way that only gave the trustee the powers you want him/her to have, such as the ability to disburse money at certain times while not having full ownership and control of it.

Also, in general, the trust is separate from the trustee legally. Just as a corporation is not "yours" in some instances, neither is a trust. The property of the trust is still the belonging of the trust even if the trustee is sued.

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    in general, the trust is separate from the trustee legally A trust is not a legal entity. It is the relationship/aggregate of the settlor, trustee and beneficiary. A trustee always owns the property in trust, otherwise it is not a trust at all. – Greendrake May 22 '19 at 20:53
  • @Greendrake: do you have a source for that assertion? I have always heard that a trust is a separate legal entity, and that the trust owns the property in question. In the same way that, e.g. SpaceX owns rockets directly, rather than Elon Musk... – sharur May 22 '19 at 21:00
  • @sharur It is in any source about trust law e.g. the Wikipedia link in my question. A trustee does not need to be a person; it can be a company, and this is what often colloquially called "trust" but is not correct in strict legal terms. And such company can become bankrupt like if the trustee was just a person. – Greendrake May 22 '19 at 21:06
  • @Greendrake being a legal entity, for the most part refers to being able to be named in legal proceedings like a corporation being charged criminally. A trust not being considered an entity or the same as a person does not mean that the trustee and the trust are one in the same legally though. – Putvi May 23 '19 at 21:25
  • @sharur I will have to find a citation, but Greendrake is correct. Neither a trust nor an estate is strictly speaking an entity, and the preferred method of identification in litigation involving a trust is, for example "Jane Doe, Trustee, of the Golden Goose Trust established under an instrument dated April 1, 1862." – ohwilleke May 25 '19 at 22:15

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