Pledging a Beneficiary’s Interest in a Spendthrift Trust

The previous post refers to a scenario in which a trustee pledges trust assets to secure a beneficiary’s personal loan. But what if, instead of pledging trust assets, the beneficiary wants to pledge his interest in the trust as security for the loan. Is this possible?

Most trusts contain a spendthrift provision. The Tennessee Trust Code defines a spendthrift provision as a “term of a trust which restrains both voluntary and involuntary transfer of a beneficiary’s interest.” Although the spendthrift clause found in most trusts is more verbose, it is legally sufficient to state the interest of the beneficiary is held subject to a spendthrift trust.

A beneficiary’s pledge of his interest in the trust is a voluntary transfer. If the interest is ever foreclosed, an involuntary transfer would occur. Therefore, a spendthrift provision would seem to absolutely preclude the pledge. However, the 2013 Restated Comments to T.C.A. § 35-15-502 say otherwise:

A valid spendthrift provision makes it impossible for a beneficiary to make a legally binding assignment or transfer, but the appropriate fiduciary may voluntarily choose to honor such beneficiary’s purported assignment or transfer, such being in reality a revocable direction or request to the trustee to pay amounts otherwise distributable to the beneficiary to the purported assignee. 

Moreover:

Note that under the immediately preceding sentence a beneficiary’s purported assignment relative to a discretionary interest may have little if any practical effect. That is because the amounts “otherwise distributable to the beneficiary” are subject to the trustee’s discretion.

In other words, even though a beneficiary cannot pledge his interest on his own, he may request that the trustee honor the pledge, and the trustee may, in the exercise of its discretion, do so.

This, of course, raises the question: why would the trustee ever do so? Doesn’t this put the trustee at risk? The comments speak to this as well:

An appropriate fiduciary is protected, and is under no liability for, honoring such beneficiary’s request, but must cease doing so upon instruction from such beneficiary. Should an appropriate fiduciary decide to honor such beneficiary’s request, such fiduciary can decide to cease to so honor it and may recommence distributions to the beneficiary at anytime. Moreover, because the beneficiary has not made a binding transfer, such beneficiary can withdraw the beneficiary’s direction but only as to future payments.

Nonetheless, before agreeing to honor the beneficiary’s assignment, the wise trustee will enter into an agreement with the qualified beneficiaries of the trust, whereby they approve the trustee’s action and hold it harmless.

Accordingly, under the right circumstances, the beneficiary of a spendthrift trust can, with the acquiescence of the trustee, pledge his trust interest to a third party.

Sources: T.C.A. § 35-15-103; T.C.A. 35-15-502 and the official comments thereto

Posted by Joel D. Roettger, JD, LLM, EPLS

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