An Overview of the Delaware Statutory Trust

By Claire M. Love and Pranav Gangele

The Delaware statutory trust (the statutory trust or DST) is a unique tool with several advantageous uses for the real estate practitioner. The 1988 adoption of the Delaware Statutory Trust Act (DSTA), codified in Chapter 38 of Title 12 of the Delaware Code (called the Delaware Business Trust Act when originally adopted), transformed the use of the DST in business transactions by providing separate legal entity status to DSTs. Before the enactment of the DSTA, a trust was a mere fiduciary relationship governed by anachronistic common law rules that were ill-fitted for application to a business trust. The adoption of the DSTA modernized the law with respect to trusts and provided certainty to parties as to the use of trusts in commercial transactions by establishing default rules with respect to fundamental issues. Moreover, the DSTA emphasizes the principle of freedom of contract, providing parties with an abundance of flexibility to structure DSTs to meet their needs and giving them the ability to effectuate business arrangements and other transactions with confidence that their intended agreement will be respected. This flexibility includes allowing choices in management structure, duration of the trust, allocation of duties and responsibilities, modification of fiduciary obligations, and limitation of liabilities of trustees and beneficial owners.

As a result of this flexibility, the use of the DST has become increasingly popular in a wide variety of commercial transactions. It is the entity of choice for holding real estate, mortgage loans, vehicles, student loans, and other asset portfolios; for issuance of mortgagebacked and asset-backed securities; and for structured finance transactions, project finance transactions, and liquidating trusts. In addition, the IRS’s recognition that beneficial interests in DSTs qualify for Section 1031 tax-deferred exchange, see Rev. Rul. 2004-86, 2004-2 C.B. (2004), has solidified the status of DSTs as the preferred investment vehicle for real estate investors.

This article provides a general overview of the DST, including the governing law, the process of forming a DST, and a discussion of several key features of the DST.

Governing Law: The DSTA— Flexibility and Freedom of Contract

The DST can trace its roots to common law trusts, specifically Massachusetts business trusts. In the early 20th century, corporations could not own real estate, so parties would use a “Massachusetts trust” or “business trust” to hold their real estate portfolios. See generally Wendell Fenton & Eric A. Mazie, Delaware Statutory Trusts, in The Delaware Law of Corporations and Business Organizations (R. Franklin Balotti & Jesse A Finklestein eds., 3d ed. 2020). Trusts were fiduciary relationships, and management of the assets of the trusts was in the hands of the trustees. The legal landscape for business trusts was primarily common law, which provided limited guidance and lacked certainty for investors, trustees, and creditors in terms of their legal rights and liabilities.

In response to the needs of the business and legal communities, the State of Delaware, already at the forefront of corporate and alternative entity law, adopted the DSTA in 1988—creating the statutory trust. The DSTA incorporated several attractive features of Delaware’s other alternative business entities within a trust structure—including separate legal entity status of the trust and limited liability for beneficial owners and trustees. In creating the Delaware statutory trust the legislature intended to provide practitioners with an easily adaptable trust form to meet the needs of sophisticated business parties.

A primary component of the DSTA is the flexibility it provides to contracting parties. The DSTA explicitly states that it is the intent of the DSTA to “give maximum effect to the principle of freedom of contract and to the enforceability of governing instruments.” Del. Code Ann. tit. 12, § 3825. To achieve this flexibility, the DSTA sets statutory default rules but largely defers to agreements of the parties and the terms set forth in the DST’s governing instrument. This allows parties to alter the default rules and contractually define many important aspects of the trust, including, but not limited to, the rights, duties, and liabilities of trustees and beneficial owners, management of the business and affairs of the trust, duration of the trust, and access to records. Many provisions of the DSTA state, “except to the extent otherwise provided in the governing instrument” before establishing a default rule to allow modification of the rules by contract. See, e.g., id. §§ 3803 (liability of beneficial owners and trustees), 3806(a) (management of business and affairs of the trust by trustees), 3809 (applicability of trust law), and 3808 (regarding existence of the trust). The DSTA is amended frequently to keep current with modern business needs and to address issues that may be unclear under existing trust law. If neither the DSTA nor the governing instrument addresses an issue, the DSTA also provides that other Delaware laws pertaining to trusts (i.e., both common law and other statutory laws) apply to DSTs unless otherwise provided in the governing instrument. See id. § 3809. Chapters 33 and 35 of Title 12 of the Delaware Code, in particular, pertain to administration of trusts and duties and liabilities of fiduciaries of Delaware trusts, and therefore can be applied to a DST unless otherwise provided in the governing instrument or covered in the DSTA. Parties should consult counsel familiar with Delaware law when drafting the governing instrument to take advantage of the flexibility of the DSTA and avoid any potential problems by overriding any unwanted default rules. Certain default rules might have an undesired effect if not otherwise altered in the trust agreement. For example, unless otherwise provided in the governing instrument, a DST has perpetual existence. See id. § 3808(a). Failure to include termination provisions in the trust agreement could make the unwinding and termination of a DST unnecessarily complicated, if not impossible.

The unique nature of the DST and the flexibility offered by the DSTA have made the DST a popular vehicle for commercial transactions. The benefit of the DSTA’s flexibility and emphasis on the freedom for parties to contract is highlighted in 1031 exchange transactions. In order for parties to comply with Revenue Ruling 2004-86 and structure deals to avoid the “seven deadly sins,” see generally Barry A. Hines & Colin C. Stouffer, Lender Perspectives on Delaware Statutory Trusts (Am. Coll. of Real Estate Lawyers working paper, Annual Meeting 2020), it is critical that parties draft appropriate restrictive provisions into the governing instrument of the trust. Any number of restrictions can be built into the governing instrument, including prohibitions on renegotiation of debt or leases, modification of the property, reinvestment of proceeds from the disposition of property, or recapitalization. The drafters can also specifically provide mechanisms for distribution of cash among the beneficial owners, establishment of reserve accounts to be funded by cash proceeds, or even the conversion of the DST into another legal entity (such as a limited liability company) upon the occurrence of certain events. Most importantly, with proper drafting, parties can achieve the desired 1031 exchange treatment and comply with IRS guidance because of the DSTA’s express intent to give maximum effect to terms within the governing instrument.

Formation of a DST

The DSTA broadly defines a statutory trust as “an unincorporated association which (1) is created by a governing instrument under which property is or will be held, managed, administered, controlled, invested, reinvested and/or operated, or business or professional activities for profit are carried on or will be carried on, by a trustee or trustees or as otherwise provided in the governing instrument for the benefit of such person or persons as are or may become beneficial owners or as otherwise provided in the governing instrument … and (2) files a certificate of trust pursuant to Section 3810 [of the DSTA].” Del. Code Ann. tit. 12, § 3801(g). To create a DST, the following four components are needed: (1) at least one trustee, (2) a certificate of trust filed with the Secretary of State of the State of Delaware (the Secretary of State), (3) a governing instrument, and (4) at least one beneficial owner (which may be identified after formation).

Delaware Trustee Requirement A DST is required to have at least one trustee who, in the case of a natural person, is a resident of the State of Delaware or, if not a natural person, has its principal place of business in Delaware, although the DSTA makes certain limited exceptions to the Delaware trustee requirement for a trust that is or will be registered as an investment company under the Investment Company Act of 1940. See generally id. § 3807. This trustee is often referred to as the “Delaware Trustee.” The Delaware Trustee supplants the need to have an agent for the service of process in Delaware. Service of process on the Delaware Trustee in accordance with the DSTA is effective as service of process on the DST itself and any other trustee of the trust. Other than the Delaware Trustee, the DSTA does not require a DST to have any other trustees, although a DST may have as many additional trustees as desired.

Organizational Documents: Certificate of Trust and Governing Instrument

The organizational documents of a DST consist of a certificate of trust and the governing instrument. The certificate of trust is filed in the office of the Secretary of State and becomes a public record. It must include (1) the name of the trust, (2) the name and address of the Delaware Trustee, and (3) any future effective date of the certificate of trust. See generally id. § 3810. It should be noted that there are some minor variations in the rules and requirements under the DSTA for DSTs that are registered under the Investment Company Act of 1940. These trusts (and related variations) are beyond the scope of, and not addressed in, this article. Certain additional provisions also need to be included in the certificate of trust if the trust elects to opt out of separate legal entity status or take advantage of the statutory limitation on inter-series liability for a trust that will be organized in series. The DSTA permits the establishment of separate series of trustees, beneficial owners, assets, or beneficial interests having separate rights with respect to specified property or obligations of the DST and allows assets, debts, and liabilities of one series to be insulated from the assets, debts, and liabilities of another series and the trust generally, provided that certain formalities are followed and other conditions are met. See generally id. §§ 3804, 3806(b). The certificate of trust must be signed by all trustees of the trust at the time of formation.

In addition to filing the certificate of trust, the trust must also have a governing instrument (commonly referred to as the “trust agreement”) at the time of formation. The governing instrument is the document or documents governing the affairs of the DST and the conduct of its business. It typically appoints the trustees and any administrators, officers, or managers of the trust, and includes provisions relating to the purpose and powers of the trust, as well as the identification of beneficial owners, operation, management, dissolution, and termination of the trust. Absent a provision in the governing instrument to the contrary, a DST has perpetual existence and cannot be revoked or terminated by the beneficial owners. When drafting the governing instrument, parties should choose what events or triggers will cause a dissolution and termination of the statutory trust. The DSTA does not dictate the form or content of the governing instrument but does require that the governing instrument be in writing. Given the deference to freedom of contract in the DSTA, careful drafting of the governing instrument is critical to the successful use of the DST. Although the governing instrument is not filed with the Secretary of State, it is entered into at the time of the filing of the certificate of trust, and the trust will not be considered duly formed without a governing instrument. In practice, parties sometimes use a “short form” or “initial trust agreement” that includes only basic provisions in order to get the trust formed in advance of closing. This allows transaction parties to open accounts, apply for licenses, complete “Know Your Customer” regulatory requirements, and perform other preliminary administrative tasks while the terms of the full-blown trust agreement are negotiated. The short form trust agreement is then amended and restated at closing after the parties have had the opportunity to negotiate and incorporate all desired provisions.

Beneficial Owner

Finally, a DST must have at least one beneficial owner. A beneficial owner is an owner of a beneficial interest in a statutory trust. Just as in a common law trust, in which the trustee holds legal title to the trust assets for the benefit of a beneficiary, the DST (or its trustee) holds legal title to the trust assets for the benefit of its beneficial owners. Under the DSTA, unless the governing instrument provides otherwise, a beneficial owner has no right to specific trust assets, but instead has an undivided beneficial interest in the trust assets and the right to share in the profit and losses of the trust in proportion to the beneficial owner’s percentage of interest in the trust. Id. § 3805(a). Notwithstanding the nature of the trust assets, the DSTA makes clear that a beneficial interest in a DST is personal property.

The DSTA leaves it to the governing instrument to determine how beneficial ownership is evidenced. Beneficial ownership interests may be certificated or uncertificated. The DSTA does not place any restrictions as to the number of beneficial owners a statutory trust may have. Therefore, subject to other applicable laws and regulations, the pool of investors in a real estate portfolio held by a statutory trust can be very large. In addition, beneficial ownership interests of a DST are freely assignable. However, the DSTA allows parties to limit or place conditions on the assignability of the interests in the governing instrument. There is a great deal of freedom under the DSTA to structure the rights and obligations of beneficial owners in the governing instrument. The DSTA allows flexibility as to the contribution of a beneficial owner, which may be in cash, property, services rendered, or a promissory note. The DSTA even allows a party to become a beneficial owner without making any contribution or being obligated to make a contribution to the trust. Parties can grant or withhold voting rights for beneficial owners, and the DSTA allows for the governing instrument to set forth provisions relating to voting rights based on classes, groups, or series of beneficial owners, and the manner in which votes can be cast, meetings can be held, and record dates can be established. It is common for the governing instrument to provide for majority or supermajority requirements to direct a trust to take certain actions, and if the trust is widely held, may provide for the appointment of a beneficial owner representative to take actions on behalf of the beneficial owners.

Key Features of the DST

There are several key features of the DST that make it a popular vehicle for structured finance and commercial real estate transactions.

Separate Legal Entity

Under the DSTA, by default rule, a DST is a separate legal entity. Id. § 3801(g). However, the DSTA has been amended to allow parties establishing a DST to opt out of separate legal entity status of the trust if such treatment is not desired. To do so, parties must specify in the governing instrument and certificate of trust that the DSTA will not be a separate legal entity. This is a departure from the common law trust, which is a mere fiduciary relationship requiring actions to be taken by and trust assets to be titled in the name of a trustee. A DST may hold property, enter into contracts, and sue or be sued in its own name. Title to the trust property may be vested in the name of the DST or a trustee of the DST.

A DST can hold property in either an active or a custodial capacity, and its property is subject to attachment and execution as if it were a corporation. Id. § 3804(a). This is particularly advantageous in real estate transactions, as it enables the trust to take title to the real estate through a purchase agreement or assignment and enter into financing with lenders directly. Therefore, lenders do not need to consider and approve each investor before providing financing. In addition, the trust may sell or swap parcels of real estate in accordance with the governing instrument. The governing instrument will often contain provisions allowing the administrator of the trust to enter into the asset disposition transactions or empowering beneficial owners to direct trustees to enter into the asset disposition transactions.

Special Purpose Entities

A DST can be organized for any lawful business or activity, but it is not required to carry on any business activity and need not be organized for profit. Id. Many DSTs are set up as special purpose entities, or SPEs, in structured finance and commercial real estate transactions in order to segregate assets and minimize insolvency risk. Often, a parent company’s risk of insolvency or negative credit is higher than lenders or investors are willing to accept, or the parent company may wish to segregate certain assets for various other business purposes. An SPE is a separate legal entity formed for a specific, limited purpose, such as holding and managing a single property or a certain portfolio of assets.

Provisions in the governing instrument of a DST that is an SPE prohibit the DST from engaging in any activity other than certain specified activities necessary or desirable in furtherance of its limited purpose. Other restrictive covenants help establish the independence of the SPE from the parent company and its affiliates by limiting the control of the parent or its affiliates over the management and operation of the SPE—thus insulating the SPE from the risk associated with a parent company’s or affiliate’s insolvency. Under the DSTA, a beneficial owner has no right to specific assets of the trust; in addition, no creditor of the beneficial owner has any right to obtain possession of or exercise remedies with respect to trust assets. Thus, once transferred to the DST, the assets should no longer be available to the parent company or its creditors, even if the depositor retains a beneficial interest in the trust. The lender can then make a loan to the DST or the DST can issue securities to investors secured by those assets without the burden of the parent’s credit risk.

In commercial real estate transactions, lenders often require certain restrictive covenants to be included in the governing instrument in order to achieve bankruptcy-remote status. Without these essential limitations on activities, purposes, and control, the possibility exists that the entity might be disregarded as a separate legal entity and the assets consolidated in an insolvency proceeding with its parent or affiliate. Under the DSTA, the bankruptcy, dissolution, or termination of a beneficial owner will not result in termination or dissolution of a DST unless otherwise set forth in the trust agreement. This makes the DST an attractive choice for parties who wish to segregate assets in a bankruptcy-remote structure.

Management Structure

The DSTA allows for maximum flexibility in the management of the business and affairs of the trust. As a default rule, the trustees of the trust manage the trust’s business and affairs. However, the DSTA grants broad authority to the parties to alter the default rule and institute an alternative management structure. Duties and powers of the trustees may be limited or expanded, delegated or assigned to other persons as agents or independent contractors of the trust, or otherwise modified as the parties see fit. Pursuant to Section 3806(b)(7) of the DSTA, a governing instrument may provide for the appointment, election, or engagement (either as agents or independent contractors of the statutory trust or as delegates of the trustees) of officers, employees, managers, or other persons who may manage the business and affairs of the statutory trust and who may have such titles and such relative rights, powers, and duties as the governing instrument shall provide. In addition, the DSTA allows the governing instrument to grant rights to any person, including persons not party to the governing instrument. In many commercial transactions, the governing instrument provides for management of the business and affairs of the trust by an administrator on behalf of the trust—usually an affiliate of the depositor or parent company. Physical custody of the trust assets is held by a separate custodian (rather than the trustee), and servicing of the mortgage loans or other assets is performed by skilled third-party servicers or asset managers engaged by the trust.

It is commonplace for governing instruments of DSTs to limit and define the duties of the trustees. For example, the duties of the Delaware Trustee are often limited to only those actions necessary to fulfill the requirements of the Delaware Trustee under the DSTA (accepting service of process in Delaware and executing documents required to be filed with the Secretary of State), and all other duties and powers are vested with other parties, such as another trustee or an administrator or manager. The DSTA also permits the trustees to be directed by a beneficial owner or third party in the management of the trust’s business and affairs. As a default rule, unless the governing instrument provides otherwise, the right or power of a party to direct the trustee does not cause such directing party to become a trustee or to have any duties (including fiduciary duties) or liabilities to the trust. See generally id. § 3806(a).

Occasionally, for purposes of achieving bankruptcy-remote status and other legal or business purposes, an independent trustee will be used. Unlike directed trustees, these trustees are required to be independent from the parent company or its affiliates and will make certain limited decisions for the trust in accordance with the terms of the governing instrument. Lenders and investors using a trust structure typically require certain control rights over some or all important management decisions of the trust. This might include making major decisions with respect to cash flows or trust assets, consenting to amendments, and determining the events that terminate the trust. The trustees or administrators will perform certain agreed-upon actions, such as execution of certain deal documents on the closing date, and otherwise will only take action as specifically directed by a directing party. This allows the directing party to control certain aspects of the trust. It is often the case that parties will limit the fiduciary duties and the standard of care of the trustees or such other managing parties, all of which the DSTA allows.

Modification or Elimination of Fiduciary Duties

One of the key benefits of the DSTA is the ability to modify or even eliminate fiduciary duties under the governing instrument. Importantly, drafters of the governing instrument should note that the DSTA does not set a default standard of care for trustees; thus, unless otherwise provided in the governing instrument, the default will be the standard applied to trustees under general Delaware trust law—a prudent person standard. See id. § 3302(a) (providing that a fiduciary must “act with care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use to attain the purposes of the account”). In addition, the trustees will have fiduciary duties applicable to trustees at common law. However, Section 3806(c) of the DSTA provides that the duties (including fiduciary duties) of trustees, beneficial owners, or other persons may be expanded, restricted, or even eliminated in the governing instrument, provided that the governing instrument may not eliminate the implied contractual covenant of good faith and fair dealing. The DSTA was amended to expand and clarify the delegation provisions, and in doing so, a default standard of care was added for delegates and other agents or independent contractors managing the affairs of the trust. Unless otherwise provided in the governing instrument or by the terms of the appointment, engagement, election, or delegation, such persons are required to adhere to the same standard of care as the trustee of the trust. Id. § 3806(n). In practice, parties almost always choose to modify or even eliminate fiduciary duties of the trustee and replace them with specific, negotiated duties and standards of care.

Limited Liability

Another important benefit of a DST is the ability to contractually limit the liabilities of the parties. Section 3806(e) of the DSTA states that liabilities of trustees, beneficial owners, or other persons may be expanded, restricted, or even eliminated in the governing instrument, provided that the governing instrument may not limit or eliminate liability for any act or omission that constitutes a bad faith violation of the implied contractual covenant of good faith and fair dealing. In most transactions involving DSTs, the parties agree that the trustee will be liable only for acts or omissions in violation of its standard of care (typically, gross negligence and willful misconduct).

In addition, there are several advantageous default rules under the DSTA that provide protection to trustees (and other managers of the trust) and beneficial owners. First, unless the trust agreement provides otherwise, a beneficial owner of a DST is entitled to the same limitation on personal liability as that of a stockholder of a Delaware corporation; therefore, a beneficial owner will not be personally liable for the obligations and liabilities of the DST. Second, the trustees or other managers of a DST, in acting in such capacities, will be liable only to the statutory trust or the beneficial owners for any act, omission, or obligation of the statutory trust or any trustee and not to any other person. Third, the trustees and other persons acting with respect to the trust are protected against liability if they act in good faith reliance on the provisions of the governing instrument. Id. § 3806(d).

Delaware Advantage

There are several advantages to forming a statutory trust in Delaware. Unlike some other entity forms, a DST is not required to make periodic filings with the Secretary of State in order to maintain its good standing and valid existence. Other than the initial filing of the certificate of trust, no additional filings are necessary until termination, when a certificate of cancellation is filed (unless an amendment to the certificate of trust is needed). A certificate of trust may be amended, restated, corrected, or canceled by following simple processes outlined in the DSTA. There are currently no Delaware franchise taxes or annual fees with respect to DSTs. For tax purposes under Delaware law, a DST is classified as a corporation, an association, a partnership, a trust, or otherwise, as is determined for federal income tax purposes. Thus, pass-through taxation may be achieved.

The business-friendly environment and sophisticated judiciary in Delaware are major advantages that should not be overlooked by parties contemplating using Delaware statutory trusts. The renowned Delaware Court of Chancery, well known for its expertise and efficiency, has jurisdiction over DSTs. In addition to Delaware’s court system, the Secretary of State is incredibly efficient and user-friendly. Finally, Delaware has numerous experienced corporate trustees and independent managers with vast experience in the use of statutory trusts in all manner of transactions.

Conclusion

The advent of the DSTA revolutionized the use of trusts in business transactions. With its innovative combination of default rules, together with flexible deference to the business needs of the parties and emphasis on the enforceability of the governing instrument, the DSTA gives certainty to parties in the use of statutory trusts, making the DST an attractive vehicle for use in structured finance and real estate transactions.

Claire M. Love is a director of Richards, Layton & Finger, P.A. in Wilmington, Delaware. Pranav Gangele is an associate at Pillsbury in Washington, DC. An earlier version of this article was distributed in connection with the American College of Real Estate Lawyers 2020 Annual Meeting.