Tuesday, July 24, 2018

Beneficiary Designations, Changed Circumstances and the Contracts Clause

Overview

For many people, the most important estate planning document is the will (or trust) that disposes of property at the time of death.  Assets that pass by will are subject to probate and are known as “probate assets.”  But, a decedent’s estate may also have “non-probate assets.”  Those are assets that are not subject to the probate court’s jurisdiction and pass by a contractual beneficiary designation.  These contractual arrangements include life insurance, pensions, IRAs and annuities. 

For married couples, one spouse typically names the other spouse as the beneficiary of these non-probate assets.  But, what if one spouse names the other as the beneficiary of a non-probate contractual arrangement and divorce occurs and the beneficiary designation is not changed?  Does the beneficiary-spouse remain the beneficiary, or is that designation automatically revoked?  Can the law automatically remove the former spouse as beneficiary?  How does the Constitution’s Contracts Clause factor into this?

That’s the topic of today’s post – beneficiary changes upon divorce.

The Contracts Clause

Article I, Section 10, Clause 1 of the U.S. Constitution specifies that a state cannot enact legislation that disrupts contractual arrangements.  That provision says that, “[n]o state shall…pass any…Law impairing the Obligation of Contracts.”  Thus, while citizens have the right to enter into contracts that don’t violate “public policy,” the government cannot impair otherwise permissible contracts.  But, what does that mean?  Does it mean that a state can enact a law that changes the contractual beneficiary designation on a life insurance policy, for example?  The issue recently came up in a case that made it all of the to the U.S. Supreme Court.

Recent Case

In Sveen v. Melin, 138 S. Ct. 1815 (2018), a couple married in 1997.  In 1998, the husband bought a life insurance policy that named his wife as the primary beneficiary and his two children from a prior marriage as the contingent beneficiaries.  In 2002, a new Minnesota law took effect providing that “the dissolution or annulment of a marriage revokes any revocable…beneficiary designation…made by an individual to the individual’s former spouse.”  Minn. Stat. §524.2-804, subd.1.  Thus, divorce automatically revokes the designation of a spouse as the beneficiary.  That would cause the insurance proceeds to go to the contingent beneficiary or the policyholder’s estate upon death of the policyholder.  If the policyholder does not want this result, the former spouse can be named as beneficiary (again).  In 2007, the couple divorced and the former husband died in 2011 without changing the beneficiary designation.  The deceased ex-husband’s children claimed that they were the beneficiaries of the life insurance proceeds.  But, the surviving ex-spouse claimed that she was the beneficiary because the law did not exist at the time the policy was purchased and she was named the primary beneficiary.  Her core argument was that the retroactive application of the law violated the Contracts Clause.

The U.S. Court of Appeals for the Eighth Circuit agreed with the surviving ex-spouse (Metro Life Insurance Co. v. Melin, 853 F.3d 410 (8th Cir. 2017), but the U.S. Supreme Court reversed.  The Supreme Court noted that the Contracts Clause did not establish a complete prohibition against states from enacting laws that impacted pre-existing contracts.  The Court noted that a two-step test existed form determining the constitutionality of such a law.  Step one involves the question of whether the law “operated as a substantial impairment of a contractual relationship” based on the extent to which the law undermined the parties’ bargain, interfered with the parties’ reasonable expectations, and barred the parties from safeguarding their rights.  If a contractual impairment is determined under step one, then the second step examines the means and ends of the legislation to determine whether the state law advances a significant and legitimate public purpose. 

In Sveen, the Court held that the law did not substantially impair pre-existing contractual arrangements.  The Court reasoned that the law was designed to reflect a policyholder’s intent based on an assumption that an ex-spouse would not be the desired primary beneficiary.  In addition, the Court stated that an insured cannot reasonably rely on a beneficiary designation staying in place after a divorce – noting that divorce courts have wide discretion to divide property, including the revocation of spousal beneficiary designations in life insurance policies (or mandating that they remain).  Accordingly, the Court concluded that a policyholder had no reliance interest in the policy in the event of divorce, and could undo the impact of the law by again naming the (now) ex-spouse as the primary beneficiary.  The decedent’s children were held to be the primary beneficiaries of the policy.

Kansas Approach

Kansas, like other states, has an automatic revocation provision for wills upon divorce.  Kan. Stat. Ann. §59-610.  For non-probate assets with a beneficiary designation, in divorce actions judges are to include changes in beneficiary status as part of the property division between the spouses and note any change in the divorce decree.  Kan. Stat. Ann. §2-2602(d).  The policyholder remains responsible for actually changing the beneficiary designation.  Id. 

Conclusion

The Court’s conclusion expands the reach of the government into private contractual arrangements.  It also assumes that all divorces are acrimonious and that a divorced policyholder would never want to benefit a former spouse.  That's simply not true.  What's more is that the Court upheld the Minnesota law even though it retroactively applied in the case at bar.  If a statute that changes (rewrites) the primary beneficiary designation of a contract on a retroactive basis doesn’t substantially impair that contract, I don’t know what does.  Judge Gorsuch seems to agree with that last point in his dissent. 

How does your state law treat the issue?

http://lawprofessors.typepad.com/agriculturallaw/2018/07/beneficiary-designations-changed-circumstances-and-the-contracts-clause.html

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