Protective Measures - By Frank W. Seneco , Russ Alan Prince - 08/1/2007
Frank W. Seneco is a life insurance specialist for the ultra-affluent and their advisors.View all articles by Frank W. Seneco
is an editor of Private Wealth magazine and the president of Prince
& Associates, Inc., the leading market research firm specializing
in private wealth. He is a highly sought consultant to the
ultra-high-net-worth and elite advisors and originated the use of
high-net-worth psychology in the financial services sector. He is the
author of more than 40 books on private wealth and is frequently cited
as an expert in the national and international press.
Step #1: The Loan
In general, the loans can come from either a commercial lender, such as a bank or even a hedge fund, or from a private lender who is often a friend or associate of the affluent client. For the purposes of asset protection, the commercial lender is often superior. The lien from the commercial lender almost always supercedes the claim from a creditor. The biggest drawback with a commercial lender is the inability of the affluent to "control" the situation. The terms and conditions of the loan, including the payment schedule, are set. Failing to abide by the terms and conditions of the loan can result in foreclosure. Also, loans from commercial lenders often are only for a percentage of the value of the property. Loans of 100% or more can be obtained, but they usually come with very high interest rates.
In contrast to a commercial lender, the affluent can turn to private lenders who are often close friends. The private lender is always a financing entity (controlled by the close friend) that provides a loan to the affluent secured by a lien against property. The terms and conditions of the loan are regularly much more flexible then with a commercial lender. For instance, the private lender can provide loans for 100% or more of the value of the property without charging a greater interest rate. The justification is that the value of the property is expected to increase during the term of the loan. Sometimes, because of the close relationship between the affluent borrower and the private lender, the matter of fraudulent transfer potentially becomes more of an issue. Thus, the entire transaction must be executed carefully and always within the letter and spirit of the law.
A variation on securing the loan from either a commercial or private lender is a hybrid approach. Here the commercial lender initially provides the loan. Subsequently, a promissory note is sold to a private lender. The commercial lender continues to administer the loan, but the private lender now can make the situation more advantageous to the affluent borrower. All the while, the creditor sees the commercial lender as opposed to the private lender and tends to be less inclined to "fight."
By taking a loan, the affluent has converted property into cash. However, cash actually is much more attractive to creditors then property. Consequently, it's imperative that the cash "disappear" in order to protect it. There are a number of ways the affluent can make the cash disappear. The easiest way is to spend it. However, if the intent is to employ equity stripping as an asset protection strategy, then it's necessary to transform the cash into another asset-an exempt asset.
Step #2: From Cash To Exempt Asset
The objective now is to transform the cash into an exempt asset. Each state has identified assets that are protected from creditors. Furthermore, the Federal Bankruptcy Act has listed exempt assets. It's critical to understand the nature of these exemptions in any particular situation in order for an affluent borrower to be protected. For instance, the exemptions only apply to natural persons as opposed to corporate entities.
The cash value of life insurance is, in many states, an exempt asset. By using the loan proceeds to purchase life insurance, the affluent are shielding from creditors the buildup of monies within the policies. When using life insurance as the exempt asset it's essential to be cognizant of the rules surrounding modified endowment contracts. In some situations, the use of private placement variable life insurance can be very useful, from an asset protection as well as from an income and estate tax perspective.
A variety of trust structures also can be employed as investment conduits. The key is getting the monies into the trust without running afoul of gift tax regulations. However, once the loan monies are in the trust, and the trust is not controlled by the affluent borrower who is also not the beneficiary, then the cash is out of reach of creditors.
Another way of transforming the cash is by using the funds to purchase a structured product. Often these are customized derivative transactions that convert the cash into a future payment or series of payments. Very often creditors, presuming they understand where the money is, often are not inclined to wait. In a similar vein, it's possible to create a deferred compensation plan that uses derivatives as the funding mechanism so that the plan also becomes a de facto exempt asset.
All in all, there are a variety of ways of transforming cash into exempt assets. Some are fairly straightforward, such as purchasing life insurance or annuities, or dropping the money in a qualified retirement account. Other more esoteric approaches involve trust structures and derivative transactions. It's all a function of the particulars of the situation.
While the basic sequential steps of equity stripping remain the same, some of the affluent are able to be more creative then others because of their unique situations. Successful hedge fund managers, for instance, can often be innovative-while solidly within the law-when it comes to equity stripping. Let's look at a couple of examples of this:
Ian's Story: With storm clouds on the horizon, Ian diminished the value of his real estate holdings (including his two houses), his jet, his yacht and his $14 million art collection, as well as $9 million in jewelry and watches. He placed all his assets in several trusts, had the assets appraised and then took out loans at the full value of the property. Ian borrowed the cash and invested it in his own hedge fund through a trust. However, he is not the beneficiary of the trust. If his hedge fund outperforms the loan rate, his family comes out ahead. Moreover, the assets are encumbered and very unattractive to creditors.
Another wrinkle in this particular transaction is that it is of the hybrid variety. The loans the trust took against the value of Ian's assets came from a commercial bank. However, a promissory note for these loans was sold to a private lender: another hedge fund where Ian has a piece of the management company. So, the creditors will see the commercial bank but not the hedge fund connected to Ian. Still, for this transaction to work, there was an arm's length relationship between the hedge fund that purchased the promissory note and Ian.
Loretta's Story: A variation of the above transaction involved Loretta, who has been in the hedge fund business for more than a decade. Lately, she has become very concerned about unjustified investor lawsuits, as well as lawsuits by almost anyone who sees her as an easy mark because of the perception that all hedge fund professionals are fabulously wealthy. She illustrates the latter with the story of a hedge fund professional she knows well who bought a guard dog for his family. Someone then intentionally baited the guard dog in order to be bitten, and after being bitten, sued the hedge fund professional for millions. This prompted Loretta to take drastic action.
She cross-collateralized her residences and her antique jewelry collection. Like Ian, she took out commercial loans that were then sold to a hedge fund in which she was a partner. She did all this through a trust. She placed the monies into a captive insurance company, which further protected them from creditors.
Loretta is using the captive insurance company to insure against the risk of litigation. In effect, she significantly enhanced her errors and omissions insurance coverage and greatly expanded the ways these monies could be used to defend her in court if needed.
These hedge fund managers used converted cash into investments in hedge funds they were associated with. At the same time, they made certain that potential creditors would find it hard to "take away" their property. While we are using examples from the world of hedge funds, the ability of the affluent to strip out the equity from property and creatively transform the cash can be employed by all of the exceptionally wealthy.
With equity stripping, the affluent client secures a loan against selected assets-most often tangible assets. Real estate tends to be commonly employed, but any asset will work. The great appeal of using real estate is that the client cannot move real estate to another location, as is possible with liquid assets and many types of collectibles.
The affluent encumbers the assets with legitimate debt. This results in a reduction in the net value of the assets, which in turn diminishes their appeal to creditors. The risk is being borne by the lender as opposed to the creditor. By then transforming the cash into another asset, the affluent protect their wealth.