Howard Fisher, Denis Kleinfeld and William Norman review the origins of asset protection and considers non-entity-based techniques to protect assets.
This article will review the origins and need for asset protection - why we are where we are. It will focus on nonentity- based techniques to protect assets, principally those revolving around contractual provisions.
Much of the liability that individuals and organisations face in the modern world arises as a result of their business activities, such as physician-patients, landlord-tenants, merchants-customers, and so on. One of the most often overlooked, and yet most effective tools for asset protection, is the strategic use of contractual provisions. These include warnings, disclaimers, shifting the assumption risk, and mandating favourable method(s) of dispute resolution (for example, arbitration and avoiding juries). These techniques should be part of the frontline of most asset protection planning.
The Law of Unintended Consequences
The “law of unintended consequences” refers to the principle that, due to the complexity of the interactions of people, especially when it comes to how they react to laws, there are unanticipated or “unintended” results.
The law of unintended consequences derives from a story involving the 14th century Indian Emperor Tughlak. To eliminate poverty, he decreed that copper coins had the same value as silver coins, thus making the poor instantly rich. However, the rich businessmen went to the treasury, exchanged their copper coins for silver ones, and then used the coins to finance trade outside of India. The result was that the poor were no better off, the rich virtually turned ‘lead into gold’, and the nation’s treasury was emptied.
In the 1960s, the so-called era of ‘peace’ and ‘anti-establishment’, many youths entered the legal profession - not to become rich ‘capitalists’, but to ‘do good for society’. Initially, these attorneys employed creative and aggressive theories, for traditional legal principles were not designed for affecting the ‘system’ for the public well-being. One element of this activism was the creation of a new breed of American lawyers who took cases to effect ‘social policy’ change, rather than for financial gain, which had a notable effect upon the actions of ‘big business’ by, for example, forcing manufacturers to make safer products.
These socially-conscious attorneys were the antecedents of the modern personal injury lawyer, who, along with their clients, tend to use imaginative and often aggressive legal theories today principally for pecuniary gain, and not social justice.
Question: You are a 79-year old lady. You buy a 49¢ cup of coffee at a fast-food drive-through. You want to add cream and sugar, but have no place to put down your cup. You place the coffee between your knees, and try to open it. Oops, you spill your coffee, and burn your thighs. What do you do?
Answer: Sue everyone! You might even engage the lawyer as you drive to the hospital emergency room. The lawyer argues that the coffee that was “unreasonably dangerous” and was “defectively manufactured”. The hot coffee should have been cooler. Perhaps there should have been a warning label on the coffee - “Don’t Put Hot Coffee Between Your Legs!”.
Outcome: $2.9 million jury award to the lady (the judge later reduced it to $640,000).5
What was the social benefit?
As a result of this one case, everyone in America is forced to endure warm, not hot, coffee.
In 1990, BMW sold a new 535i to Dr. Gore of Alabama, without disclosing that it had made some minor repairs worth $601 before shipping the car to the dealer. When Dr. Gore received the car from the dealer, it looked perfect, and he never noticed that it had been repaired until nine months later when an independent dealer mentioned it to him.
Dr. Gore sued BMW for fraud, and sought punitive damages based on all vehicles whose repairs were undisclosed. The jury awarded Dr. Gore $4,000 for the reduced value of his car, and $4 million in punitive damages. Fortunately, the Supreme Court, in a 5:4 decision, overturned the punitive award. However, not everyone has the money to defend the case all the way to the highest court of the land.
Thus, what started out as an adjunct to the ‘peace movement’ ultimately spawned a litigation craze, and a plaintiff ’s bar playing the “litigation lottery” - without regard to the social cost.
The Problem Persists
The United Sates is a country of many ‘firsts’. Not a day goes by without some extraordinary claim being made by some alleged “victim” seeking to win the “litigation lottery”. This continues today, as the following two examples from 2007 show:
In some instances, like in the coffee incident above, there is no excuse for the outrageous award. In these two 2007 cases, the real damages are so nominal as to not even warrant the costs of the filing fee. However, some lawyers always seem willing to roll the dice. The so-called ‘tort reform’ has done nothing to impact the unmeritorious claims of some plaintiffs.
The Problem Spreads
The global explosion of frivolous litigation is now penetrating western Europe, and will soon infect other regions of the world. The traditional attitude towards litigation in Europe, coupled with the fact that in many countries the ‘loser’ pays legal fees, originally served as a buffer against American-style litigation. However, in our modern society, greed seems to trump good every time.
Even if you are from a jurisdiction that is insulated from US-type litigation, you may not be immune from its effects. The reach of US courts has proven to be extraordinary. For example, the US’ Alien Tort Claim Act of 1789 has been used to ‘reach out and drag’ foreigners into the United States for alleged slavery in Myanmar (formerly Burma), and torture in Paraguay. So beware, nowhere are you safe!
The Origin of Asset Protection Entities
Asset protection is an ancient concept. The use of entities for asset protection pre-dates both the Statute of Henry VII of 1487 (limits on self-settled trust), and the Statute of Elizabeth I of 1571 (first fraudulent conveyance statute). The ‘use’, a precursor to the common law trust, was employed in England from the Middle Ages onwards for asset protection. For example, in 15th century England, speaking out against the Crown was considered treason, resulting in forfeiture of land and property. To circumvent this, during the War of the Roses (1455), it was common for the followers of both Lancaster and York to hold all of their land in a ‘use’, thus allowing them to continue their ‘treasonous’ activities without risk of confiscation.
The earliest corporations date from about 1500, and were chartered by the Crown (for example, King Charles I chartered the Massachusetts Bay Company in 1628 to colonise the US). In terms of asset protection, a fundamental principle of corporations since inception has been the limitation on liability; that investors (shareholders) are not liable for the debts of the company.
Risk Management Model
The most important aspect of asset protection planning is the fundamental business concept of “risk management”. In other words, determining what the sources of potential liability are, and then addressing those sources. This aids in focusing on the severity of the potential problem, and leads toward viable solutions.
For instance, realising that the client owns substantial rental property, and that there are concerns regarding tenants, helps to focus on the potential source of the liability and possible actions to address that liability. For example, they could insulate each property in a separate entity, ensure prompt responses to complaints and repairs, maintain good documentation of actions taken, take pro-active and preventative action at the properties, and insure the known risks.
Often, liability can be minimised by taking action that reduces the client’s exposure to the source of known liabilities.
Much of our potential for liability arises out of business activities, and has its genesis in some type of contract, be it informal (for example, purchasing goods in a supermarket - offer, acceptance, implied warranty of fitness, and quality, and so on), or a formal contract where you sign an engagement letter with your attorney. Sometimes it lies somewhere in between, such as when you go to a new doctor and must fill in a variety of forms.
One of the most often overlooked, and yet most effective tools for asset protection is the recognition that certain actions and activities are ‘contractual’ in nature, and then employing appropriate contractual provisions, such as disclaimers, waivers, and limitations on damages.
Not all Contractual Provisions will be Effective
Often a contract that violates public policy is ‘void’. Also, courts that are always looking out for the ‘little guy’ may find ways to limit contractual provisions, by declaring, for example, that it is a contract of adhesion, or it is ‘fundamentally unfair’. However, having the protective provision is always better than not having it; at the very least, it adds leverage in any settlement.
Sometimes there are statutes that limit certain types of contractual provisions, such as forbidding you from waiving liability for fraud or wilful injury. Some courts have developed tests as to when liability waivers will be permitted.
Limitation on Damages
Consider provisions that limit the amount or nature of damages:
“You Agree to Limit any Damages and Liability
The undersigned agrees that, in the event of any claim for negligence or breach of contract, [Person X] agrees to limit any liability and damages to [no.] times the amount of fees that the undersigned has actually paid to [Office] for services that gave rise to the claim of negligence or breach of contract. [Office] agrees not to pursue any claim against you other than for an outstanding balance, and to waive any claim for consequential damages against the undersigned.” [Initialled by Person X]
To minimise the potential issue of adhesion, consider adding the following:
“If the undersigned does not want to agree to this Consent, we can discuss what language you are uncomfortable with or do not like, and I will consider eliminating that language.
DO NOT SIGN THIS CONSENT , and request to speak with [Person Y] about changing this Consent, which [Office] is willing to do, if you so request. If we cannot reach agreement, then [Office] will refer the undersigned to appropriate emergency facilities, hospitals with clinic operations, several other local physicians, and/or will refer you to ‘physician referral services’ who will aid you in finding another [Required Service].” [Initialled by Person X] 7
“The parties hereby waive all general, special and consequential damages, and agree that damages shall be limited to the amount of the fee paid under the engagement, less an amount equal to the firm’s hourly rate of $[X] per hour, multiplied by the hours actually expended on behalf of the client’s matter.”
No Piercing of the Corporate Veil
Consider contractual limitations that prevent the entity’s corporate veil from being ignored or ‘pierced’. The suggested language is as follows:
“If a corporate party breaches this Agreement, the non-breaching party agrees to look solely to the assets of the breaching corporation in satisfaction of any damages incurred, or judgment obtained as a result of the breach. The non-breaching party waives any claim that it has against the breaching corporation to pierce the corporate veil, or to otherwise disregard the corporation. The shareholders, corporate officers, directors, employees, attorneys, agents, or affiliates of the breaching party shall not be liable under, or with respect to, this Agreement.”
A variation of the above clause can also be used with LL Cs, partnerships, and trusts.
As juries have been known to deliver verdicts based upon emotion, in many circumstances it is best to have a judge or other professional render the decisions. Consider employing a ‘jury waiver’ such as:
“In a court proceeding to interpret or enforce this Agreement, each of the parties to this Agreement waive their respective rights to a jury.”
Note, in some jurisdictions it may not be possible to waive a jury in the absence of an arbitration provision.
Alternative Dispute Resolution - Arbitration
Private judging (or arbitration) is often preferable to a proceeding within the ‘judicial system’. This is so for many reasons, including the ability in arbitration to select the judge or judges (retired trial, appellate, or state supreme court judges often provide such services), and the selection of the applicable procedural law, with appropriate limitations (for example, limitations on discovery are often used in a commercial context, although they may not be viable in employment or consumer situations). Consider a simple arbitration provision, such as the following:
“The parties will attempt to resolve their disputes through ‘good faith’ negotiation. The term “disputes” inc ludes , without limitation, their disagreements concerning the formation, construction, or interpretation of this Agreement. If the parties are unable to resolve a dispute by negotiation, then the parties waive their right to seek a judicial determination, and agree to submit all disputed matters to binding arbitration before a retired California judge, who, at the time of their retirement was a member of the [Court of Appeal/ Supreme Court] (“Judge”). The Judge shall be selected by [insert details]. As a precondition to the right to resolve this matter, each party shall pay one half of the fees requested by the Judge. This arbitration provision shall be specifically enforceable, and any award may be entered as a judgment by a court of law. The parties agree to limit discovery to: [50 interrogatories, 25 requests to produce, and three depositions (not to exceed six hours each)]. The rules of evidence shall not apply to any hearings before the Judge. The decision of the Judge is final, and may not be appealed or otherwise challenged.”
Third Party Indemnity
Consider requiring the party with whom you are contracting to provide an indemnification from third party liability. Consider, for example, in a lease, or a physician-patient engagement, language such as the following:
“You Will Pay if Anyone Else Sues Me
If anyone other than myself sues you (for example, my husband or my child) with regard to any services you provide to me, I will indemnify you, and will reimburse you and/or pay for any fees, costs, damages, liability or judgment that you incur as a result of anyone other than myself suing you as a result of any services you provided to me.” [Initialled by Client/Patient]
Choice of Law Provisions
The laws of some states may be more favourable to debtors than the laws of other states or jurisdictions, for instance, by imposing limitations on punitive damages, or the ability to waive a jury trial.
With regard to the selection of the applicable law, most states tend to follow the principles set forth in the Restatement of Conflicts (second). Section 187 provides: “The law of the state chosen by the parties to govern their contractual rights and duties will be applied…” However, the jurisdiction in question cannot be one that has no connection to either party, for if a company has offices in 50 states, it can select the state law that is most beneficial to the company.
There is a major distinction between (i) a ‘choice of law’ provision in a contract where the parties are in privity, and attempting to force a choice of law upon third parties, such as tort victims, and (ii) the ‘choice of law’ rules relating to trusts, and the law of the trust’s application to third parties, such as creditors.
Choice of Forum
Closely allied to a choice of law provision, is a choice of forum provision. In M/S Bremen v. Zapata,9 the Supreme Court recognised the right of parties to a contract to agree on the forum in which to resolve their dispute. This may mean that there could be a ‘home town advantage’, or one state’s ‘procedural law’ may be more beneficial to one or both of the parties, such as statute of limitation, discovery, exemptions from attachment, and so on.
In 1991, the Supreme Court in Carnival Cruise Lines, Inc. v. Shute,10 gave consideration to a forum selection provision in a consumer contract for a cruise ship. The plaintiff lived in Washington, boarded a ship in California, and was injured in Mexico. The ‘ticket’ provided that all claims be litigated in Miami. The Supreme Court upheld the agreement to litigate in Miami, where Carnival had an office, even though such choice of law provision may, as a practical matter, eviscerate the consumer’s claim ( Richards v. Lloyd’s of London, 107 F.3d 1422, 1430 (9th Cir. 1997)).
In a limited partnership and a limited liability company, a creditor may only be able to obtain a “charging order” against the interest of a debtor that requires all distributions with respect to the charged interest to be made to the creditor. In Revenue Ruling 77-137, the IR S held that a creditor holding an involuntarily assigned partnership interest is treated as a substitute partner, and is taxable for the distribution share of any income allocated to the interest, even if no income is actually distributed.
By including a provision in the partnership or operating agreement to allow the general partner or manager to retain earnings and not make distributions, a creditor with a charging order against a partner may have to report “taxable income” each year that the charging order is in place, but the creditor will receive absolutely no cash, and will have to pay tax on the allocated income. The partnership/operating agreement should contain provisions similar to the following:
“ ‘Available Cash Flow’ shall mean total cash revenues received by the Partnership (other than net capital proceeds), less cash expenditures, operating expenses and amounts set aside for reserves.
The General Partner, in its sole and absolute discretion, may establish reserves, and not make distributions of cash to the Partners. This may in some circumstances result in taxable gains or taxable income being allocated to partners, without the partners’ receiving cash to pay the tax on the income so allocated.”
Marital Property Agreements
There are two basic types of marital property agreements : prenuptial agreements and postnuptial agreements. From an asset protection viewpoint, a timely marital property agreement may limit the assets available to settle future claims of judgment creditors to only one of the two spouses. This is particular important in ‘community property’ states.
Offshore is still King of the Structures
Although contractual provisions should be a part of all comprehensive asset protection planning, there are limitations as to both the situations in which it can be used, and its effectiveness. Hence, there will always be room for the strategic use of entities as part of any comprehensive asset protection plan.
The use of domestic ‘asset protection trusts’ commenced on April 2, 1997, with the enactment of Alaska’s statute scheme. Certain aspects of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 were intended to specifically address asset protection. However, both of these developments are too new for there to be any case law that provides necessary guidance for good planning. Accordingly, offshore structures for certain aspects of asset protection are still the most viable.
It must be acknowledged that frivolous litigation, or “the litigation lottery”, is not likely to abate. It is no longer limited to the United States, but is rapidly becoming a global practice.
Contractual provisions are the technique that should be employed in most situations, even if the client does not engage in the full spectrum of planning opportunities. 11
1 Mr Fisher is based in Beverly Hills, California. He is a member of the California Bar, and the Honourable Society of Lincoln’s Inn (London [student bencher]). Mr Fisher is a graduate of the University of Southern California (B.A.), Southwestern University (J.D.), and the University of Cambridge (LL.B.with honours).
2 Denis A. Kleinfeld is based in Ft. Lauderdale, Florida. He is a graduate of the University of Illinois (B.S. in Accountancy, 1967) and is a Certified Public Accountant, and his J.D. is from Loyola University of Chicago.
3 Mr Norman is based in Los Angeles, California. He a member of the California Bar. He has a J.D. from the University of California (Bolt Hall), and an LL.M. (in Taxation) from New York University. He also attended the Graduate School of Business of University of California at Berkeley, and the Stern Graduate School of Business of New York University.
4 Mr Fisher is a graduate of the University of Michigan (BA - Econ/Comm 2004), Emory University School of Law (2007), and is currently completing an MBA at Emory.
5 See, http://en.wikipedia.org/wiki/ McDonald’s_coffee_case.
6 BMW of North America, Inc. v. Gore, 517 US 559 (1996).
7 California Civil Code § 1668.
8 Tunkl v Regents of Univ. Of CA (1963) 60 C2d 92.
9 407 US 1 (1972).
10 111 S. Ct. 1522 (1991).
11 S e e , f o r e x amp l e , Ja c k s o n v. Commissioner ¶ 81-594 PH Memo T.C. (1981); Willis, Partnership Taxation, § 2.03.
Denis Kleinfeld is highly regarded as a lawyer, teacher and author. His private legal practice, Kleinfeld Legal Advisors, is located in North Miami Beach Florida. He is an Adjunct Professor at the LLM Wealth and Risk Management Program, Texas A & M School of Law. His private practice focuses on strategy planning of domestic and international tax, legal, financial, matters involving the wealth and risk management for private clients and private businesses. He is co-author of the two-volume treatise, “Practical International Tax Planning,” 4th Ed. published by Practicing Law Institute. He is the contributing author on Foreign Trusts published in “Administration of Trusts in Florida” by The Florida Bar and authored chapters for the American Bar Association’s in “Asset Protection Strategies: Wealth Preservation Planning with Domestic and Offshore Entities Vols. I and II.” He is a contributing author to the “LexisNexis Guide to FATCA”.
Mr Norman is based in Los Angeles, California. He a member of the California Bar. He has a J.D. from the University of California (Bolt Hall), and an LL.M. (in Taxation) from New York University. He also attended the Graduate School of Business of University of California at Berkeley, and the Stern Graduate School of Business of New York University.
Mr Fisher is based in Beverly Hills, California. He is a member of the California Bar, and the Honourable Society of Lincoln’s Inn (London [student bencher]). Mr Fisher is a graduate of the University of Southern California (B.A.), Southwestern University (J.D.), and the University of Cambridge (LL.B.with honours).