Denis Kleinfeld outlines why advisors need to have a full understanding of the law of contempt.
The credit crunch and economic slowdown have created even more liability litigation than usual. As can be reasonably expected, there will be a number of creditors who will find their target debtors have engaged in asset protection manoeuvres. Much of this will be structured using domestic planning, such as exemptions and limited liability entities. Some will soon enough discover that their quarry has utilised international trusts and other vehicles.
The litigation process is not that complicated: it comprises two parts. First, prove liability; then go try and collect on the judgement. Many planners seemingly rely on the mantra that being in an offshore jurisdiction will provide all the protection they need from judgement collection. The problem is that the assets may be offshore, but the settlor’s body is in a US courtroom subject to being held in contempt. In reality, defending a judgement debtor in a coercive civil contempt proceeding is where, ultimately, the tyre meets the road when it comes to asset protection planning.
To assure the effectiveness of an asset protection plan, advisors should understand the circumstances in which creditors may successfully challenge the plans and legal structures in court. That means having a solid understanding of creditor-debtor law, the legal concept of contempt of court, and the defence of impossibility.
The legal battle between creditors and debtors has become a confusing muddle through various seemingly conflicting legal decisions and, in particular, legal commentators. The basic principles of creditor-debtor law were outlined by the US Supreme Court in Grupo Mexicano de Desarrollo v. Alliance Bond Fund. The specific holding was that a federal district court had no authority to issue a preliminary injunction preventing the disposition of assets pending adjudication of a claim for money damages. The Supreme Court based its decision on the traditional rule of law that a general creditor has no cognisable interest, either at law or in equity, in a debtor’s property. Essentially, a general creditor, that is one without a judgement, has no legally recognised property interest in the assets of a debtor before getting a judgement. And until there’s a judgement, it’s lawful for debtors to do whatever they want with their assets.
Is solvency an exception to this rule? The Court stated: “This Court has concluded that that particular exception does not exist.” The Court also recognised that, at least since 1861, before a creditor gets a judgement against a debtor, the debtor “may convert one species of property into another, and he may alienate to a purchaser”.
As regards an ability of a court to issue a prejudgement attachment, the Supreme Court rejected the adoption in the US of the English Mareva injunction. While the Mareva revolutionised legal practice in the UK the Court considered it as interfering “with the debtor’s disposition of the property at the instance of a non-judgement creditor”. The conflicting views of Justice Scalia, for the majority, and Justice Ginsberg, for the dissent, are most illuminating.
Justice Ginsberg argued that the Court should be the arbiter of “progressive social conditions” and recognise that debtors may employ “sophisticated foreign-haven judgement-proofing strategies, coupled with technology that permits the nearly instantaneous transfer of assets abroad, to avoid meritorious claims.” Justice Scalia took the opposite view, stating: “[We] suspect there is absolutely nothing new about debtors trying to avoid paying their debts…or even about their seeking to achieve these ends through ‘sophisticated…strategies’.”
In simple terms, the majority of Justices recognised that long-accepted common law principles provide that debtors have complete dominion over their property. Creditors do not have any rights, legally or equitably, until they get a judgement. Debtors can even transfer their money to an offshore asset protection trust.
The legal system, through statutes that obviate the common law rules, does provide debtors with some contra-legal weapons. A creditor can always just bring suit and then, after judgement, pursue collection remedies. Before judgement, a creditor can invoke an applicable statutory prejudgement attachment remedy. A creditor also can possibly bring a bankruptcy action that would similarly allow a prejudgement freeze of assets. Lastly, if the assets are transferred, a creditor could pursue remedies under a relevant fraudulent conveyance law. What US law recognises is that debtors and creditors both have legal rights and, importantly, each are fully entitled to exploit them to the extent the law allows.
As with any legal proceeding, there is the potential that a contempt of court proceeding may arise during the course of litigation. In general, a court imposes contempt of court on a person who embarrasses, hinders or obstructs the court in the administration of its proceedings or lessens the court’s authority or dignity. The reality is that contempt is very much a judicially subjective determination. As a result, lawyers are always concerned about a client crossing the contempt line and subject to being punished by a judge who may not understand the parameters of the law of contempt – or care.
The Supreme Court has a number of case decisions which provide the framework of the law of contempt. Basically, these can be summarised as: contempt is either civil or criminal; then either direct or indirect. The different types are governed by different sets of legal standards and procedures. Lawyers need to understand this legal matrix to avoid confusion and be able to effectively advise their client in what will be a hotly contested matter.
Criminal contempt occurs when the purpose of the contempt proceeding is punishment. This may arise when there is offensive conduct directed towards the court resulting from its judgements, orders or processes. As a criminal proceeding, all constitutional due process safeguards are applicable. For example, if the court orders someone not to issue press releases and a party then does so, the court can vindicate itself (after complying with due process requirements) by putting the offending party in jail for a set period of time or by imposing a fine payable to the court.
Civil contempt occurs when the purpose of the proceeding is to coerce action or is remedial in nature. As a civil proceeding, it’s directed towards preserving and enforcing rights of private parties involved in a lawsuit or is used to compel obedience to orders made for the benefit of a private party. This would arise, for example, when a court requires certain documents be brought before it. If that is not done, the court can impose a daily fine to be paid to the other party, or incarceration, until the documents are produced.
Within civil contempt are compensatory civil contempt and coercive civil contempt. Direct contempt is viewed as a contemptuous act done in the presence of the court. For example, a party is ordered to refrain from speaking on a certain issue and continues to do so in the presence of the judge. On the other hand, indirect contempt, sometimes referred to as ‘constructive contempt’, is a contemptuous act done outside the presence of the judge. The judge issues an order that a case should not be discussed in public, but the party so ordered does so but outside the courtroom, and thus triggers the indirect contempt provisions.
Civil contempt can result in two possibilities for punishment. First, compensatory civil contempt allows the court to order payment of money to a party of the lawsuit to compensate for monetary losses sustained as a result of a contemptuous act by the other party. For example, one party fails to show up at a deposition and the court orders the legal fees incurred by the other party to be paid. Second, coercive civil contempt arises when the court feels that a threat of punishment – such as a fine or imprisonment – is necessary to force a party to comply with the court’s order.
In asset protection planning, indirect coercive civil contempt is the most likely form of contempt proceeding to arise. This typically would occur where a judge orders a debtor to repatriate money from a foreign trust and the debtor does not comply. As a result, the judge orders imprisonment until the time the money arrives at the courthouse. The key to the jailhouse door is when the money arrives. Then the contempt is purged, and the ‘contemptor’ is free.
Generally, only a person with standing before the court can bring notice and a motion for an indirect coercive civil contempt action. As with any civil proceeding, the moving party has the initial burden of proof to specify in the motion and notice the acts claimed to be contemptuous. It is not an automatic proceeding. The standard of proof is a preponderance of the evidence, although some courts require a clear and convincing evidence standard.
Once the creditor has established non-compliance by the debtor or the debtor admits non-compliance, the burden shifts to the debtor to show that there’s a present inability to perform. This is the legally recognised excuse of ‘impossibility’. If the debtor cannot demonstrate impossibility, then a court may impose a coercive penalty, such as a fine or imprisonment for an indefinite period of time. Importantly, as the Supreme Court has stated, even when the act causing the impossibility is reprehensible, such conduct “does not warrant issuance of an order which creates a duty impossible of performance so that punishment can follow.” As a matter of law all coercive civil contempt actions must have a purge provision. A court is, therefore, allowed to use a fine or incarceration in coercive civil contempt only where the debtor has the present ability to perform but refuses to do so. If there is a fine, it is paid to the other party, not the court. If there is incarceration, the period may be indefinite, although at some point coercion becomes merely punishment, which is then impermissible.
What if the debtor himself purposefully creates the impossibility? Almost a quarter of a century ago, the Supreme Court in Rylander unequivocally said: “Where compliance is impossible, neither the moving party, nor the court has any reason to proceed with the civil contempt action.” This is logical since, where an action is impossible, it cannot be purged. Without an ability to purge, coercive civil contempt is unallowable. Some other form of contempt or legal sanction may or may not apply, but it certainly cannot be coercive civil contempt.
This principle of law has received much publicity in a number of highly-publicised cases such as FTC v. Affordable Media, LLC also known as the Anderson case, and In Re Lawrence. Essentially in these cases the courts made some broad statements which, as dicta, may or may not have been the correct rule of law. However, in those cases the court in fact did not find the impossibility defence was proved by or allowable to the judgement/debtor. Contrary to whatever these lower courts have stated, or pundits have commented, the Supreme Court is clear that ‘impossibility’, even if self-created or self-induced, is a complete defence to a charge of coercive civil contempt.
This principle of law was upheld in May this year by the Federal District Court in the Southern District of Florida. Simply, the Inland Revenue Service (IRS) was trying to collect US$36,000,000 from Raymond and Arline Grant. The money was reportedly sitting in a trust in Jersey. The court recognised that Mrs Grant (as Mr Grant had died) tried to repatriate the funds but had not been successful. Accordingly, Mrs Grant was able to “sufficiently establish” that she was not able to repatriate the “offshore funds” and the IRS contempt request by way of a rule to show cause was denied.
The issue of contempt of court always looms large whenever litigation, or even a threat of litigation, arises. This is highlighted in those cases involving international protection structures. Knowledgeable professional planners need to fully understand the law of contempt. They must not only be able to inform their client, but may also have to some day educate a judge.
Denis Kleinfeld is highly regarded as a lawyer, teacher and author. His private legal practice, Kleinfeld Legal Advisors, is located in North Miami Beach Florida. He is an Adjunct Professor at the LLM Wealth and Risk Management Program, Texas A & M School of Law. His private practice focuses on strategy planning of domestic and international tax, legal, financial, matters involving the wealth and risk management for private clients and private businesses. He is co-author of the two-volume treatise, “Practical International Tax Planning,” published by Practicing Law Institute. He is the contributing author on Foreign Trusts published in “Administration of Trusts in Florida” by The Florida Bar and authored chapters for the American Bar Association’s in “Asset Protection Strategies: Wealth Preservation Planning with Domestic and Offshore Entities Vols. I and II.” He is a contributing author to the “LexisNexis Guide to FATCA”.