Alabama joined approximately 20 others states this year by enacting the Qualified Dispositions in Trust Act. At its core, the Act allows individuals to enjoy asset protection found in trusts without many of the stringent restrictions on control usually associated with trusts. Fortunately, the Act provides tools lenders can use to minimize the impact of this Act on collection efforts, but lenders must be proactive in using these tools. Because individual business owners and investors - who often are guarantors of loans - are expected to take advantage of the Act, lenders should begin using these tools now.
Trusts have long been used to protect assets from the reach of creditors, but with the advantage of asset protection came the disadvantage of losing control of the assets. The Act lessens that disadvantage Under the Act, the individual establishing the trust (i.e., the “settlor” or “transferor”) is able to transfer assets into a trust and if certain conditions are met, the transfer constitutes a “qualified disposition.” The settlor then is able to direct investment decisions, veto distributions proposed by a trustee, receive income generated by from assets in the trust, and use real estate held by the trust. The Act also enables the settlor to remove a trustee for any reason or no reason at all.
Transfers into trust satisfying the qualified disposition criteria can only be attacked as a fraudulent transfer. However, the typical 4-10 year statute of limitation that applies to fraudulent transfers is reduced to two years with few exceptions. Moreover, the Act also entitles a trustee acting in good faith who defends a creditor’s fraudulent transfer claim to a lien on the trust assets made the subject of the attack for the defense costs. This lien has priority over existing liens on the assets giving it super-priority status. But there is good news for lenders. The Act recognizes the freedom of contract and expressly says agreements are binding that require prior consent of the lender in order for a transfer into a trust to constitute a qualified disposition. Importantly, transfers into a trust in violation of these agreements will not constitute a qualified disposition.
Why is this important? A lender could underwrite a loan in strong reliance on a guarantor’s personal financial statement. Immediately after the loan’s closing, the guarantor could transfer substantially all of their assets into a trust through a qualified disposition. Once two years pass from this transfer, the assets cannot be recovered should the loan default except in extremely limited circumstances. But this crisis can be avoided by the lender and guarantor agreeing at closing that assets transferred into a trust are not qualified dispositions under the Act unless the lender expressly consents before the transfer.
As is typical, there are important nuances to the Act that are outside the scope of this discussion. Lenders should consult with their counsel to better understand the Act and how best to protect their interests in light of the Act.