Wherein I Violate the First Rule of Fight Club

I am headed to Singapore next Tuesday night for a weekend mastermind meeting with a small group of entrepreneurs. The program has been organized by Dynamite Circle, an offshoot of Tropical MBA. Subscribe to the podcast, by the way. Recommended. Yep. I will be in Singapore for Chinese New Year. This topic is one that I know will come up in conversation at the mastermind event (I have been warned). “People are interested in foreign trusts.” Although no one is willing to say the words out loud, it is pretty clear why foreign trusts are on topic. So let me blurt out the words and clear the air. Asset protection. Done. I’ve just violated the first rule of Fight Club.

Set the Stage

Let’s imagine a future risk. Five years from now you will be sued. Extremely generic business litigation. Nothing special, except if you lose the lawsuit your company will be wiped out. High stakes, normal risk. You will be considerably less stressed as you go through the lawsuit if you know that a few million dollars sits in a bunker, safe, waiting for you after the dust has settled – even if you lose the lawsuit. How do you go from cocktail party conversation to done? Today I am going to cover the first hurdle. You can’t move forward until you solve this hurdle.

TL;DR

Here’s how to think about setting up foreign trusts for asset protection purposes.

• Fight Club. The first rule of doing asset protection planning is to not say you are doing asset protection planning. It’s not going to look good in court when your creditors sue you and say you intended to run away from your debts.
• Identify Risks. You are really doing risk management. You can’t manage risks until you know what and how big they are.
• Bulletproof Funding. Can you get money out of your pocket and into the trust without fraudulent transfer risk? (That’s what I will talk about in this episode of the Friday Edition).
• Control. You will have no control over that giant bucket of your money. Srsly. You might never see it again. Are you OK with that?
• Tax. Assume you can’t ever get the money in the trust, but you still have to pay income tax on the dividends, interest, and other income earned in the trust. Are you OK with that? (Not necessarily going to happen, but quite possible.)

There are other things to think about but let’s stop there. It’s Thursday night, and I’m at a Coffee Bean & Tea Leaf working on a vanilla iced blended and waiting for my birthday girl daughter (14 today) while she walks around the Americana in Glendale with her buddies. Let me just say this. Four girls, 50 dumplings at Din Tai Fung. Plus two orders of spicy noodles. This time, I’m just talking about the problem of getting money permanently into your trust without having it blow up in your face later. (I have seen and fixed plenty of blown up foreign asset protection trusts.) In legal jargon, I’m talking about fraudulent transfer rules. Some other time, if you feel like it, we will talk about other factors.

It is Safe if You Don’t Own It

Let’s now explore the first constraint to achieving your objective of asset protection. Until you have solved this problem, don’t bother proceeding to the rest of the constraints.

Key Legal Principle: If it ain’t yours, it can’t be seized to pay your debts.

Asset protection is, at its base, a simple idea. You are responsible for your own debts. Your income and your assets can be seized to pay your debts. American Express cannot come and foreclose on my house if I don’t pay my credit card bill. But they cannot foreclose on your house. The whole objective of asset protection strategy is to safely and definitively say “I do not own it” and have that assertion stand up in front of a hostile judge.

The Definition of “Yours”

The problem we are about to address is the definition of “yours”. Sometimes, an asset can be treated as “yours” even if you don’t own it, and your creditors can seize the asset from the person who owns it in order to pay your debt. The way that your creditors can grab assets even after you have given them away – to a foreign trust, for instance – is using a set of legal principles called the fraudulent transfer rules. These laws say that a creditor can grab someone else’s property to pay your debts if three things are true:

• You transferred the property to that other person;
• The effect of the transfer was to make you insolvent; and
• You did this with a certain state of mind – an intent to short-change your creditors.

If all three are true, and if a judge agrees, then the creditor will be permitted to seize the asset that you transferred to someone else. For the purpose of satisfying your debts, that thing that you used to own but don’t now will be treated as if you still own it. That’s a fraudulent transfer. Applying it to the creation of a foreign trust for asset protection purposes, you will transfer money to the trust. If the transfer makes you insolvent and you made the transfer with the intent of putting assets out of reach, your trust might be forced to return assets to you for immediate seizure by your creditors. Note that if you make a transfer – intending to put the money out of reach of your creditors, you can do that deliberately and with intent. If you remain solvent after the transfer, then there is no fraudulent transfer and your creditors cannot pursue the asset. Note also that if you make a transfer and you are insolvent because of it, you can still be safe if you can prove that you are all innocent ‘n stuff and you did not intend to put money out of reach of your creditors. But good luck with that. No one except your Mom will believe that, and she only believes you because she loves you.¹ To recap: an insolvency-inducing transfer of assets, coupled with mal-intent. That’s what makes a fraudulent transfer. Defeat one or both, and the money you transferred to the asset protection trust will be safe from that mythical lawsuit coming at you in five years.

Solve This Problem First

For our purposes it is not necessary to get into the niceities of what it means to make a fraudulent transfer. When are you insolvent? Etc. In a general sense, here is what is involved: you must be rendered insolvent (look at a balance sheet test and a cash flow test), and you must make the transfer with an intent to put the money out of reach of your creditors. Nor is it necessary to explore the depths of human consciousness and determine whether there was an intent to defraud creditors. I just want you to see the two major moving parts in this machine. Exploring the definitions of insolvency, or determining your state of mind? This is where you spend $150,000 in legal fees to protect the money you put into the foreign trust. Before you set up the trust, you absolutely want to get this right. But not right now. It is sufficient for your purposes to know that this is a problem. If you cannot transfer assets out of your name cleanly and permanently, then you face the prospect of expensive litigation to protect the assets in the trust.

How Foreign Trusts Make It Happen

One of the selling points for trusts in some countries (notably the Cook Islands) is the existence of strong local laws that are designed to defeat fraudulent transfer attacks by a creditor. This is done in three ways.

Way The First – Start Again, My Friend

First, these local laws require that a creditor claim against a trust must be filed in local courts, starting over. If a creditor sues you in California and wins a judgment against you for $1,000,000, that’s not the end of the story. The creditor cannot take a piece of paper from California and collect money in the Cook Islands. The creditor must start suing you again, from scratch, in the Cook Islands courts. Tactic: more expense, more time incurred by your creditor.

Way The Second – Large Opening Ante

Second, this litigation is happening in a country that follows a “loser pays the winner’s legal fees” rule. (This is common outside the United States.) So when your creditor sues you in the country where you establish the foreign trust, the court will require the creditor to deposit a large sum of money (or a bond) to cover your legal fees if you ultimately win. The opening ante for your creditor to sue you again is then the cost of hiring lawyers plus the cost of depositing a large sum of money with the court to make sure that your legal fees will be satisfied if you win. Tactic: more expense for your creditor.

Way The Third – Brief Windows of Time

Third, the local laws in the country of your choice will have relatively short time periods in which the creditor can sue you and claim a fraudulent transfer to the trust – maybe two years from the date of funding the trust. This means you have (from the local court’s perspective) assurance that a lawsuit will simply not be allowed if brought after the time deadline. If you created the trust in 2012 and put money into it in 2012, you will know that the money is safe in 2014. Any lawsuit brought in the local courts will simply be bounced. And this (BWoT), ultimately, is the strongest of your defensive weapons, particularly if your facts are a tiny bit manky. Tactic: statute of limitations.

Counterattack by Creditors

What if all of your money is in a foreign trust and you are in the United States? Well, your money might be out of reach of a U.S. creditor and U.S. courts, but you are not. Expect to be squeezed by the courts. The counterattack is contempt of court. You are ordered to cause the trust to decant money back to you, in order to pay your creditors. You, of course, claim you have no such power and you prove it by doing exactly what the judge orders, with the expected result of no money transferred from the trust to you. The judge, in varying levels of grumpiness, is grumpy and imposes penalties (up to and including jail) on you for failing to obey a court order. You claim it is impossible for you to comply with the judge’s order therefore you cannot be in contempt of court for disobeying it. The judge says “You created the condition of impossibility, so go cool off in jail.” Hilarity ensues. Not. Again, let’s not get into the technicalities of how contempt of court works and the outer reaches of your risk of actually being threatened with this. For our purposes we focus on the principles involved. And those principles are, to recap:

• The first barrier to successfully funding a foreign trust is the fraudulent transfer issue.
• Success depends on making your transfer to not be a fraudulent transfer, or by using the local law where you set up your trust to protect a transfer – fraudulent or not – against attack. Or use both strategies if you are smart.
• Your opponent’s strategies are to aim for the assets (using the fraudulent transfer attack) or aim for you personally (using the contempt of court attack).

How To Do It?

How do you fund a foreign trust and create a good defense against a fraudulent transfer claim?

Mindset

Understand that you are planning for litigation. You expect to be sued, and you expect a claim of fraudulent transfer to be made by your opponent. You have the opportunity to create the evidence for that future litigation, so why not do a good job at getting ready? Note that I am not saying that you should make stuff up. I am saying that you should take the opportunity to prepare for battle by arming yourself with the best possible weapons. Winter is coming.

Build Objective Proof

Prove that your transfer is not fraudulent. The cleanest way is to point to objective facts: before and after the transfer, you remained solvent. Do this by hiring someone to render an opinion that before and after your transfer of funds to the trust you continue to be solvent. Or, you can prove (as a practical matter) that you remain solvent after putting money in your foreign trust by transferring a ridiculously small percentage of your wealth to the trust, guaranteeing that you will be financially solvent after the transfer. But where is the protection in that? You still have the vast bulk of your wealth exposed to risk. You will be sued, and a claim of fraudulent transfer will be made against you. Build objective facts by neutral parties that make the desired conclusion blindingly obvious. This will get expensive. Who is going to give you a solvency opinion if they know you will be sued? The fee you pay them must compensate for the cost and aggravation of being a witness – or worse yet, a co-defendant – in the creditor’s litigation against you and the trust alleging fraudulent transfer.

Ignore the Intent Part

It is much harder to prove what you were thinking in your head when you made the transfer. Remember the First Rule of Fight Club Asset Protection? You don’t talk about asset protection. Doing so looks like you were trying to put money out of reach from your creditors. Do your best here but don’t rely on proving your state of mind as your defense in court against a fraudulent transfer claim.

The Country’s Laws

Finally, select a country for your trust with strong laws that favor your position. Look for the short and definite “close the door after N years to all fraudulent transfer claims” type of law, especially.

Why So Much Preparation?

Why am I so anal-retentive about preparation? Simple. Every dollar you spend now will save you $500 in legal fees later, and will reduce the risk of that will lose.

One-Way Only, No Exit

If you can surmount the funding problem – eliminate the fraudulent transfer risk – then you have the beginning of a good asset protection solution. Money can go into the foreign trust, and it cannot come out again to satisfy your creditors’ claims. There are many, many other ways to (offensive verb deleted) up an asset protection structure and create an unwanted exit for your money. But a clean funding is the first essential step to the asset protection planning. Until you figure this out–how are you going to get assets out of your name and into the trust without a fraudulent transfer problem?–there is not a lot of point in moving forward.

Disclaimer

As usual … I’m not your lawyer, and this is not legal advice. Hire someone to tell you the answer.Seriously. Especially for this stuff.

Questions? Suggestions? Need More?

Thanks for reading. Topic suggestions and comments are always welcome. Shoot me an email by hitting “Reply” and send me your thoughts. /Phil.