BETA
This is a BETA experience. You may opt-out by clicking here

More From Forbes

Edit Story

The Common But False Myth Of The Asset-For-LLC Interest Exchange In Asset Protection Planning

Following
This article is more than 8 years old.

Among the many false myths about asset protection planning is the belief that a debtor in financial distress can transfer certain of his valuable assets to a charging order protected entity ("COPE"), i.e., a partnership or LLC, and that transfer cannot as a matter of law be held to be a fraudulent transfer because the debtor is receiving "reasonably equivalent value" in return in the form of an equally-valued partnership or membership interest ("COPE Interest").

The theory behind is that a debtor can convert their valuable assets into a COPE Interest, and thus protect those assets from creditors, who can't collect against those assets because they are now owned by the COPE and not the debtor. Instead, the creditor is limited to a Charging Order against the debtor's COPE Interest, which is really just a lien that catches distributions when and if made (and of course none will be made for the creditor to pick up).

So in the end analysis, the creditor goes from being able to collect against valuable assets to being stuck with a lien of dubious value against the debtor's new COPE Interest. However, it is precisely this result that blows up "reasonably equivalent value" and makes the transfer relatively easy for a creditor to set aside as a fraudulent transfer.

In Interpool Ltd. v. Patterson, 890 F.Supp. 259 (S.D.N.Y., 1995), just a week before the debtor went trial in New York in a civil case against him, the debtor and his wife, being Florida residents, transferred just over $1.4 million in assets to RMC Holdings LP, a limited partnership controlled by the debtor and his wife.

The debtor lost his trial, and a judgment against him for over $4.8 million was entered, and shortly thereafter the creditor moved to void the transfers in violation of New York's fraudulent conveyances laws.

Noting that "reasonably equivalent value" is always measured from the perspective of creditors, the Court held that the debtor (Cuneo) and his wife had committed a fraudulent transfer and thus rendered themselves judgment proof:

Cuneo has done just that by rendering his $1.4 million in property virtually unreachable by the judgment creditor. Cuneo exchanged $1.4 million in cash and securities for general and limited partnership interests in RMC in which he received essentially three rights—the right to receive income and capital distributions from the partnership, the rights in the specific partnership property, and the right to participate in management. Creditors can reach only Cuneo's right to the receipt of whatever distributions that the partnership—consisting only of Cuneo and his wife—chooses to makes, but cannot reach his rights in specific partnership property or, far more important, his right to participate in management. Viewing the transfer from the standpoint of Cuneo's creditors and their legal rights vis-a-vis Cuneo's partnership interests, the conveyance was not an exchange for equivalent value.

The debtor argued that Florida law, not New York law, should apply, but the Court held that it didn't make any difference since the transfers would have been voidable under Florida fraudulent transfer law as well. In the end, the Court entered a Turnover Order for the property that the debtor and his wife transferred to RMC Holdings LP.

The Interpool result has been the same with cases arising under Section 548 of the U.S. Bankruptcy Code, which is bankruptcy's fraudulent transfer provision.

In Schaefer v. G.R.D. Investments LLC, 331 B.R. 401 (Bk.N.D.Iowa, 2005), an Iowa farming couple were sued in Oklahoma for breach of a grain contract, and lost that case to the tune of $127,125. Wife filed for bankruptcy, but it was dismissed, and thereafter the couple sought the services of an Iowa attorney who helped them form G.R.D. Investments LLC, and transfer all their non-homestead real property to the company in exchange for a fifteen-year "employment agreement" that paid them a small wage each year and guaranteed health care benefits.

The Bankruptcy Trustee then filed an adversary action to avoid the transfers under both Iowa's Uniform Fraudulent Transfers Act and Bankruptcy Code § 548.

The Court noted that since the couple managed G.R.D., it was a statutory insider under the Iowa UFTA. The Court also noted the absence of anything like an arm's-length sale of the property to G.R.D., and that the couple (the Schaefers) would earn equal salaries even if they put in unequal labor; plus, the healthcare benefits would be provided to them regardless of cost. Thus:

Notwithstanding Schaefers’ failure to prove that any portion of the stream of benefits is not truly wages, there are aspects of the arrangement which support an inference that the intent of the agreement was to defraud creditors. The qualitative terms of the employment agreement were not based on the value of Larry and Elaine’s services in the marketplace. Larry and Elaine received identical salaries, without regard to whether they performed different tasks or worked different numbers of hours. Larry said that if he and his wife were unable to perform the physical work of managing the properties, they could hire someone else to do it. The agreement guaranteed Schaefers’ wage income at a higher level than they had ever had before, regardless of whether G.R.D. would continue to own the properties transferred to it in 2001. The agreement guaranteed health care coverage without regard to cost. The term of the contract was based on Schaefers’ desire to have regular, substantial income and guaranteed health insurance coverage until they received Social Security benefits.

Schaefers cannot have it both ways. If the value of their promise to provide labor to G.R.D. was economically equivalent to the compensation to be paid them, the compensation should not be attributed to the real estate transfer in determining whether they received reasonably equivalent value for their property []. However, if it was not economically equivalent, the transfer was structured by Schaefers to put their non-exempt property out of the reach of their creditors, and in the hands of their sons, while Schaefers were financially distressed. The court concludes that the transfers to G.R.D. were a fraudulent arrangement between Schaefers and their sons to shield non-exempt assets from the parents’ creditors by converting them to “exempt wages.”

The Schaefers also argued that they were in "good faith" in regard to the transfers to G.R.D. because they had acted on the advice of their counsel. But after reviewing several pertinent prior court opinions on the subject, the Court concluded:

The sense of the cases is not that a debtor will be excused from actual fraudulent intent if he has sought legal advice for the execution of a fraudulent scheme. A defense of advice of counsel may overcome an inference of fraud or willful misconduct, but the defendant must show a full disclosure of all relevant facts to the attorney and a reasonable belief that he was receiving reliable advice.

As the debtors failed to make any showing as to what they told their lawyer, and what he told them, regarding G.R.D., the Court rejected this defense.

These cases are just examples of how the courts have dealt with the assets-for-interest exchange in the fraudulent transfer context. The issue is very important because the concept of "reasonably equivalent value" plays a critical role in a fraudulent transfer analysis.

There are several tests as to whether a given transfer is a fraudulent transfer, but there are two main tests that encompass the vast bulk of reported cases:

The first test is an intent test under Section 4 of the Uniform Voidable Transactions Act (formerly called the Uniform Fraudulent Transfers Act). The intent test is referred to somewhat erroneously as the "actual fraudulent transfer" test, and simply has two elements: (1) the debtor made the transfer with the intent to defeat creditors, and (2) the transfer was without "reasonably equivalent value".

The second test is a balance-sheet test under Section 5 of the UVTA which has utterly nothing to do with the debtor's intent, but instead looks exclusively to two elements: (1) the debtor was insolvent at the time or the transfer or made insolvent because of the transfer, and (2) the transfer was without "reasonably equivalent value". This test is the so-called, and even more erroneously named, "constructive fraudulent transfer" test.

Note that both of these test require the creditor to prove that the transfer was without "reasonably equivalent value". This is always proved from the viewpoint of creditors, and the consideration paid to the debtor for the transfer must have what is known as "utility to creditors", meaning that the creditor can get the same value out of what was received as what was transferred.

This is not to suggest that all transfers by a debtor to a COPE, even one in deep financial distress, will ipso facto fail to rise to the level of reasonably equivalent value. Let's say that a debtor transfers $1 million in cash for a like value in a privately-traded hedge fund organized as an LLC and managed by a reputable third-party manager. On the day after the transfer, the debtor could -- if he wanted -- easily cash out his interests for about the same $1 million. In such a case, that transfer probably constituted "reasonably equivalent value".

Of course, this is very different from the typical distressed debtor case as described above. Usually, the transfer is to an LLC that is owned or controlled either by the debtor, or by an insider. The LLC usually has no or minimal other assets, and often the ink of the formation papers filed with the Secretary of State haven't fully dried.

Then, there is the transfer. Usually the transfer is dollar-for-dollar, meaning $1 of assets for $1 of interests. Estate planners should immediately recognize the problem with this, which is that with a COPE a $1 of assets isn't worth for tax purposes $1 interest in the COPE. Estate planners take the position with great frequency that $1 of assets is not worth $1 of interests in the COPE for the precise reason involved here: The interest received is subject to various restrictions, such as lack of marketability and lack of control, etc. -- this is exactly what torpedoes the transfer for reasonably equivalent value purposes as shown by the above cases.

Almost always these cases involved a debtor who panics when he realizes that creditors might come knocking at the door, and doesn't just make a transfer to a COPE, but also makes other contemporaneous transfers that belie whatever excuse the debtor has made for making the transfer to the COPE. With UFTA section 4 actual intent ("actual fraudulent transfer") cases, the court doesn't look at particular transfer in a vacuum, but rather looks at the totality of the circumstances surrounding the transfer to divine the debtor's real purpose, with those circumstances expressed as the so-called "Badges of Fraud".

The point is that these late transfers to a COPE will usually be set aside as a fraudulent transfer, and the statements often heard to the contrary at asset protection seminars are a good way of determining whether the speaker knows that he or she is talking about. It's also a good question for clients to ask their planners to determine whether they are minimally competent in this area.

You know, circumstantial evidence of the planner's competency. It's also a good question for clients to ask their planners to determine whether they are minimally competent in this area.

You know, circumstantial evidence of the planner's competency. Or Badges of Competency if you prefer.

This article at http://onforb.es/1agrcUW and http://goo.gl/Vpdth5