Delaware Statutory Trusts

Business trusts have been recognized by the Delaware common law since 1947, however, there was no express statutory recognition of the business trust in Delaware until the passage of the Delaware Statutory Trust Act (originally named the “Delaware Business Trust Act”), 12 Del.C. c.38 (the "Act"), in 1988. The Act was drafted by a committee of the Delaware State Bar Association comprised principally of practitioners who focused their practices in the corporate finance area. The goal of the drafting committee was to increase the utility of the business trust in modern financing transactions by overruling those principles of the common law of trusts which were deemed disadvantageous and including certain new provisions to statutorily authorize a high degree of freedom of contract between the trustor and the trustee in determining their respective liabilities and the manner in which the trust could be administered. The Act expressly includes all pre-existing statutory and common law with respect to trusts, except to the extent that any such law conflicts with the Act or the terms of the governing instrument of a Delaware Statutory Trust (“DST”) formed under the Act. The success of the Act is measured by the vast number of DSTs currently being used in asset securitizations, leveraged lease financings, mutual fund offerings and a variety of other financing transactions.

Under traditional common law principles, the administration of a trust is vested in a trustee who is charged with broad fiduciary obligations to the trust and its beneficiaries. Such obligations not only prevent the trustee from delegating any of its discretionary authority with respect to the management to the trust, but also impose a strict standard of care on, and limit the indemnity available to, the trustee in fulfilling such obligations. The administration of many modern business trusts, however, requires specialized knowledge outside the scope of expertise of corporate fiduciaries. Allowing the beneficiary of a trust (or anyone else) to control the business decisions of the trustee runs the risk under common law that the trust will be deemed an agency instead of (or in addition to) a trust with several disastrous results: the beneficiary may become liable for the obligations of the trust, and the creditors of the beneficiary may be able to disregard the trust and reach its assets to satisfy related or unrelated obligations of the beneficiary. In addition, a trustee who improperly delegates its discretion may become personally liable for any resulting losses and may not be able to be held harmless against, or indemnified for, such losses to the extent they are caused by any actual or imputed negligence of the trustee.

Under the Act however, a beneficiary of a DST has express authority to control the trustee (or even to act as a trustee itself) without running any risk of personal liability or any risk that its creditors could get to the assets of the trust. Indeed, the Act provides that a beneficiary of a DST shall have the same limitation of personal liability as is extended to stockholders of private corporations for profit and that no creditor of a beneficial owner has any right to obtain possession of, or otherwise exercise legal or equitable remedies with respect to, the property of a DST.

In addition, the DST Act expressly provides protections to trustees of DSTs. For example, the Act provides that to the extent a trustee has duties (including fiduciary duties), and liabilities relating thereto, to a business trust, to another trustee, to a beneficiary thereof or to a third party, such duties and liabilities may be expanded, restricted or eliminated by the trust's governing instrument, and a trustee shall have no liability for its good faith reliance on the terms of such governing instrument. This means that any duties, obligations, or liabilities of a trustee of a DST may be limited, or even eliminated, by the terms of the DST’s governing instrument. (The one caveat to this limitation is that a governing instrument may not eliminate any claim or liability from a trustee’s violation of the implied contractual covenant of good faith and fair dealing.)

Likewise, under the Act, a DST has express authority to indemnify and hold harmless the trustee, beneficial owner or another person from and against any and all claims whatsoever, subject only to such restrictions as are set forth in the trust's governing instrument.

Further, the Act provides that, except to the extent otherwise expressly provided in the governing instrument of the trust, a trustee “shall not be personally liable to any person other than the statutory trust or a beneficial owner for any act, omission or obligation of the statutory trust or any trustee thereof.” These provisions offer substantial protections (and comfort) for trustees of DSTs in that the liabilities that a trustee may face can be strictly limited while the protections afforded by indemnification can be very broad.

Virtually every modern financing involving a DST requires, as a practical matter, that the trust be deemed a bankruptcy remote entity vis-à-vis the beneficiary thereof. Apart from the trustee control problems noted above, under the common law, a sole settlor/beneficiary of a trust generally has the power to terminate the trust at will, notwithstanding any agreement to the contrary set forth in the trust's governing instrument. Such a power prevents the creation of a bankruptcy remote entity because under bankruptcy and insolvency principles, a creditor stands in the shoes of its debtor, and if a debtor has the power to terminate a trust and reach the trust's assets, then a creditor of such debtor also has such power. Under the Act, however, except to the extent provided in its governing instrument, a DST has perpetual existence and may not be terminated or revoked by a beneficial owner or any other person, or otherwise terminated by the death, incapacity, dissolution, termination or bankruptcy of its beneficial owner.

In addition to modifying many principles of common law such as those discussed above, the Act also makes applicable to DSTs many new provisions of law. Under the Act, a DST is a separate legal entity and may carry on any lawful business or activity, whether or not conducted for profit, including holding or otherwise taking title to property. Also, for purposes of taxation under Delaware law, a DST is classified as a corporation, an association, a partnership, a trust or otherwise, as determined under the Internal Revenue Code. Furthermore, a DST may merge or consolidate with or into one or more other business trusts or other business entities, and in connection therewith, rights or securities of, or interests in, a DST may be exchanged for or converted into cash, property, rights or securities of, or interests in, any other constituent party to the merger. However, in order to take advantages of the protections offered by the Act, Delaware law imposes the requirement that at least one of the trustees, if not an individual resident in Delaware, have its principal place of business in the State of Delaware.

As a result of the certainty with respect to the limited liability of beneficial owners and trustees and the protection of trust assets from creditors, as well as the inherent flexibility with respect to the manner of administration of a business trust formed under the Act, DSTs are currently being used not only in place of common law business trusts but also as replacements for other business entities in a wide variety of financing transactions. The only apparent limitation on the use of a DST in the finance area is the imagination of the drafter of the trust's governing instrument.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations. Attorney Advertising.

© Morris James LLP

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