I’ve recently had a few clients approach me about an asset protection technique that is being heavily promoted on cruises and in seminars. It’s mostly marketed to those with significant investments in real estate, and it’s called equity stripping.
Put simply, equity stripping is encumbering real estate with liens to make it unattractive to a creditor. For instance, if I own a $1 Million piece of property with no mortgage and I lose a lawsuit, that property is available to be foreclosed upon to satisfy the judgment. On the other hand, if that property has a $1 Million lien against it, there is no equity in the property for that judgment creditor to pursue.
While equity stripping can be done as a legitimate technique, for it to hold up it must have some commercial substance. Because of this requirement, it will be a viable technique for only a very small subset of clients.
The type of equity stripping generally hyped in seminars fails the test of commercial substance. The hyped techniques generally involve the client first forming a “finance LLC” owned solely by the client. This “finance LLC” then borrows a bunch of money from a nontraditional third party lender. The “finance LLC” then lends the borrowed money to the client, taking a mortgage over the client’s property in return. The client then takes the pot of money (which has now been lent twice) and contributes it to the “finance LLC” to capitalize the entity. The “finance LLC” then uses that money to repay the original loan from the third party lender. The loan from the third party lender is now extinguished, but the loan between the “finance LLC” and the client remains, along with the related mortgage lien. Because at this point there is no money to actually repay the loan, the note between the LLC and client is usually some sort of balloon note payable on demand.
With this setup, at the end of the day, the client has his properties fully mortgaged with no real responsibility to pay anyone back, as he sits on both sides of the transaction.
The problem with this arrangement is that it won’t be respected as “real” by a court in the event the client is actually sued, particularly if the client ends up in bankruptcy.
With regard to a lien such as the one described above, bankruptcy courts apply a five factor test to determine if it is legitimate. No one factor controls, and the court looks at the totality of the circumstances. The five factors are:
- the adequacy of the capital contribution
- the ratio of shareholder loans to capital
- the amount or degree of shareholder control
- the availability of similar loans from outside lenders
- certain other relevant questions such as (a) whether the ultimate financial failure was caused by under-capitalization; (b) whether the note included payment provisions and a fixed maturity date; (c) whether a note or other debt document was executed; (d) whether advances were used to acquire capital assets; and (e) how debt was treated in the business records.
In re Kids Creek Partners, L.P., 212 B.R. 898, 931 (Bankr. N.D. Ill. 1997) aff’d, 233 B.R. 409 (N.D. Ill. 1999) aff’d sub nom. In re Kids Creek Partners, 200 F.3d 1070 (7th Cir. 2000) and aff’d sub nom. Herzog v. Leighton Holdings, Ltd., 239 B.R. 497 (N.D. Ill. 1999). If a lending arrangement fails the test, the lien is ignored.
The hyped equity stripping scheme described herein will fail most or all of the five factors listed above. It fails Factor 3 because the real estate operation and finance LLC are controlled by the same owners. It fails Factor 4 because no outside lender would make a loan to the real estate operation on the loose terms imposed by the finance LLC. It fails Factor 5 because the Note has no real fixed maturity date and the advances were not used to acquire real assets.
For the attorneys reading this post, it is also important to note that according to the cited case, the above test can be applied to recharacterize debt to equity even if the requirements of equitable subordination are not met. Equity stripping is risky business.