Introduction
The topic of “Asset Protection” has become a “hot item” in estate and business planning literature in recent years, fueled by the failure of publicly traded companies, shareholder actions against officers and directors and S.E.C. actions against officers and directors of publicly traded companies as well as the ever present willingness of members of our society to blame others for their misfortune and to find attorneys willing to litigate the point.
We had to draw some conclusions and make some assumptions in preparing this presentation. Also temporal necessity has limited this presentation. We will not discuss insurance coverage which is the first defense to attacks by many creditors. Competent business planning or estate planning counsel, however, should always alert the client to the importance of the full spectrum of coverage available and the quality of the carriers providing the coverage. Like lawyers, all liability insurance carriers are not alike, and good insurance counseling is important to asset protection.
Also, while we will briefly discuss offshore and domestic asset protection trusts, each of those topics can only be appreciated after long study and not as part of a 30-minute presentation. While the ABA volume entitled Asset Protection Strategies, Planning with Domestic and Offshore Entities, edited by A.A. Bove, Jr. (2002), provides a slightly dated but a good overview of these topics, the efforts of the presenters at the University of Miami Heckerling Institute over the last several years will provide more specific insight.1
Background
The various techniques, forms of ownership or entities discussed in this presentation have to be viewed in relationship to laws prohibiting conveyances which result in frustration of a creditor’s rights to enforce collection of debts or judgments from the debtor’s estate. These laws generally fall into two categories: 1) The Uniform Fraudulent Transfer Acts of the various state;2 and 2) Provisions in State law3 and the Bankruptcy code4 regarding assets exempt from collection proceedings and inclusion in the Bankruptcy Estate.
In most cases, a transfer will be subject to attack under a fraudulent conveyance statute only if the person transferring the asset is insolvent or is rendered insolvent as a result of the transfer. Generally, whether it be under Illinois law or the Bankruptcy Code, insolvency is defined as the existence of one of two conditions. The debtor is either unable to pay his obligations as they become due or has debts which in sum exceed his assets’ fair market value.5
Transfers made by debtors for less than fair market value resulting in the debtor’s insolvency are fraudulent; and transfers made by debtors to affiliated persons or parties (“insiders”) for an antecedent debt are fraudulent as to a creditor whose claim arose before the transfer if the debtor was insolvent and the affiliated transferee knew of the insolvency.6 Similarly fraudulent are any transfers made by debtors intended to hinder or delay collection.7
Under the Bankruptcy Code, transfers made within 90 days of filing are presumptively preferential and will generally be reversed. The Trustee in Bankruptcy can also look back as far as six months to reverse preferential transactions. This applies independent of the fraudulent conveyance principals above.8
The asset protection devices, techniques and conveyances discussed below must all be considered in light of the insolvency, fraudulent conveyance; and preference principles, and careful study of the appropriate statutes and the interpretive cases is essential to good asset protection planning.
This is generally the battleground. It is all about insolvency, preferences, fraud on a creditor and when the conveyance occurred. For this reason the topic should be called “Asset Protection PLANNING.” While most clients come to the attorney focused on “asset protection,” the really operative term in the phrase is PLANNING. All too often when you first meet the client many of the opportunities are unavailable because the client is already aware of the claim and therefore may be insolvent and is looking to hinder or delay a known creditor. The business and estate planning attorney is well advised to put Asset Protection PLANNING at the top of his or her checklist for the first interview and to refuse to drop the subject when the client says “oh, we don’t need that now.” Your answer should be “good, that means now is the time to do it!” Later may be too late.
Also, under the heading of “zealous advocacy” consider Morganroth & Morganroth v. Norris, McLaughlin & Marcus, P.C. et al9 in which the Circuit Court of Appeals found that a cause of action existed against a debtor’s law firm for fraud, conspiracy and aiding and abetting because the law firm’s conduct exceeded permissible advocacy and amounted to a scheme to defraud a creditor.
Protected assets
The planner’s arsenal in asset protection is impressive. Many of the types of property ownership and types of assets available for protection have multiple benefits, and multiple reasons to be used as part of most thoughtful estate plans.
Tenancy by the entirety is the statutory form of spousal ownership of a primary residence which prohibits the creditor of one spouse from executing on the entirety real property to satisfy a judgment or debt.10 Importantly, the courts have found that conveyance of the primary residence into tenancy by the entirety even after the creditor claim is known, even though it is a transfer to an “insider” under the Fraudulent Transfers Act, is effective to defer the foreclosure collection process because the legislature, in passing the act, intended to trump the Fraudulent Transfers Act in this restricted instance if the avoidance of payment was not the “sole intent” of the debtor.11 Whether the marital domicile is a community property state and the existence of state “homestead” exemptions are also important factors in the planning process.
Pension Plans, Retirement Plans and IRA assets are also protected from judgment, attachment, execution and seizure for satisfaction of debt by statute.12 Even when the payments to the plan are by an insolvent with probable fraudulent intent, once the funds are in the protected plan, under ERISA, the assets cannot be withdrawn based on claims of preference, fraudulent transfer or insolvency.13 This seemingly harsh rule of law has been diluted somewhat by the 2005 revisions to the Bankruptcy Code which generally except from the bankrupt estate only $1 million of qualified funds.14
Illinois law also provides protection from creditors for insurance and annuity policy proceeds & cash values when the contracts are payable to immediate family members of the insured or annuitant.15 However, the payment of premiums by an insolvent under Illinois law creates a presumption of fraudulent intent which is irrefutable and conclusive regardless of motive.16 Thus, once a claim or liability is clear and identifiable, if it arguably creates insolvency, a huge single premium annuity purchase will not likely protect the’ value from the creditor.
Transfers between husband and wife are common and incur no gift tax liability because of the unlimited marital deduction for gift tax under the Internal Revenue Code. It is a common estate planning technique to divide marital assets into legally separate estates or into two separate trusts, one each for husband and wife. Under the law of all noncommunity property states, this separate legal ownership insolates one spouse’s assets from the other’s creditors. This simple modification of common or joint ownership of property when executed in the setting of estate planning and before creditors are identified has the salutary effect of protecting half the asset base from the other spouse’s future creditors. Once the assets are separated, obtaining credit based on separate personal financial statements helps protect assets from bank creditors as well.
Limited Partnerships, and Limited Liability Companies more recently, have become popular estate planning vehicles for their characteristics justifying illiquidity and minority interest discounts to asset value for gift tax and estate tax purposes. The partnership agreements and operating agreements in conjunction with the controlling statutes provide a significant degree of protection from the creditors of limited partners and members. Under the Illinois acts, which are not too dissimilar from the Delaware and Uniform Acts, the assets of the Partnership or the Company are not viewed as assets of the equity owners (partners or members). Their asset is the interest in the entity. The entity is not the debtor, the member or partner is. The entity cannot be forced by the creditor of the member or partner to divest itself of the asset. Under the statutes, all the creditor of the limited partner or member can do is obtain a “charging order” and foreclose on the order,17 which requires the entity, if it distributes on the foreclosed interest, to distribute to the creditor.
Carefully drafted agreements generally do not require distributions and because these entities usually are treated as partnerships for income tax purposes, the foreclosing creditor could receive no distribution but receive a K-1 requiring him to pay income tax without receiving the income.18 Additional planning in the operating agreement and partnership agreement can further protect the entity’s assets by providing other equity owners with options to purchase the foreclosed interest from the assignee (creditor) at deep discounts, though that does not help the debtor much. While courts in some states, like California, have recently suggested a charging order is not a sole remedy against an interest in Limited Partnerships or LLCs, Illinois courts suggest it is exclusive.19 Recently proposed legislation to amend sections of the Limited Liability Company Act to specifically provide that the charging order was not the exclusive remedy of a member’s creditor was defeated in the Illinois legislature. Transfers to limited liability companies or limited partnerships suffer from the same infirmities that we have previously discussed. Such transfers which are in violation of the Fraudulent Transfers Act may be subject to remedies under that Act. We can find no cases on this. Therefore, as explained above, the time to transfer assets to the limited partnership or limited liability company is when all is rosy and solvent, not when the lawsuits are being filed. The careful attorney will document the file with clear evidence of the solvency of the client after the investment in the limited liability company or limited partnership and the good business reasons for the investment.
Asset protection trusts
Trusts were developed as asset protection devices but their effectiveness in this regard was substantially curtailed by the 16th century Statute of Elizabeth at English Common Law. Current Fraudulent Transfer Acts are the progeny of this statute and the strong policy against the effectiveness of self settled spendthrift protection trusts in the United States.20
However, asset protection through the use of some irrevocable trusts is possible. A solvent client may have several reasons for establishing a Qualified Personal Residence Trust, an Irrevocable Life Insurance Trust, a Minors Trust, or an Irrevocable Trust for the benefit of a spouse. Gifts under the Uniform Transfers to Minors Act similarly are not subject to the creditors of a donor who was solvent at the time he made the gift. However, the grantor may not have a beneficial interest in these trusts.21
These third party settled spendthrift trusts protect trust property from the beneficiaries’ creditors in almost all American jurisdictions.22 To the extent such trusts are for the benefit of the debtor’s spouse or children, the subsequently insolvent debtor may gain some indirect benefit.
Some offshore common law jurisdictions, in an effort to obtain foreign capital (originally in an effort to avoid income taxation of European citizens), have repealed the Statute of Elizabeth and do not recognize foreign judgments and do recognize self settled, discretionary trusts with spendthrift clauses. These jurisdictions have become the suggested venues for asset protection. The cost and complexity of establishing such trusts is significant. The battle ground, even then, will be insolvency, preference, and the hindrance or delay of creditors because most clients only consider the extreme of an offshore trust only when the threat of creditors is very real. That is too late. Even if all the debtor’s assets are “over there,” the contempt power of the court can make life miserable over here.23
Nine states now provide asset protection from creditors to beneficiaries of self settled spendthrift trusts known as DAPTs.24 These are discretionary trusts and a complete discussion of the provisions of the various statutes is well beyond the scope of the presentation.25 Suffice it to say here that these relatively new statutory DAPTs have yet to be tested in the courts. The challenges are many including the touchy constitutional problem of giving full faith and credit to court orders and judgments of sister states, a problem not experienced by offshore trusts. Disclaimers by insolvent debtors do not provide a method of protecting inheritable assets from creditors, as least not when the creditor is the Internal Revenue Service. State law may reach a different conclusion regarding a state judgment creditor.26
Conclusion
Asset protection is an important part of business and estate planning. Many techniques are available to help the business client but the sooner these issues are addressed the better the chances that misfortune in business will not devastate a business person’s entire estate.
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1. Richard W. Nenno, Chapter 3: Relieving Your Situs Headache: Choosing and Rechoosing the Jurisdiction for a Trust, 4oth Annual University of Miami School of Law Philip E. Heckerling Institute, pp. 3-73 and 3-109, 110 (2006); Richard W. Nenno, Chapter 1: Domestic Asset Protection Trust Comes of Age, 38th Annual University of Miami School of Law Philip E. Heckerling Institute (2004).
2. 740 ILCS 16011 et seq.
3. 735 ILCS 5/12-1001 et seq.
4. 11 U.S.C. s749; 11 U.S.C. 9764; 11 U.S.C. 91306.
5. 740 ILCS 16013 (Under 11 U.S.C. S101. “insolvent” is defined as a financial condition such that the sum of such entity’s debts is greater than all of such entity’s property at a fair valuation).
6. 740 ILCS 16016.
7. 740 ILCS 16015.
8. 11 U.S.C. 9547; 735 ILCS 5112-1001.
9. Morganroth & Morganroth v. Norris, McLaughIin & Marcus, P.C., 331 F.3d 406 (3””C ir. 2003).
10. 735 ILCS 5112-11 2.
11. Harris Bank of St. Charles v. Rav Weber, 298 Ill. App. 3d 1072; 700 N.E.2d 722 (1998); Premier Property Management, Inc. v. Chavez et al, 191 Ill. 2d 101; 728 N.E.2d 476 (2000).
12. 735 ILCS 5112-1 006.
13. Patterson v. Shumate, Jr., 504 U.S. 753; 112 S. Ct. 2242; 119 L. Ed. 2d 519 (1992); Guidry v. Sheet Metal Workers National Pension Fund et al, 493 U.S. 365; 110 S. Ct. 680; 107 L. Ed. 2d 782 (1 990).
14.
15. 735 ILCS 5112-1001 (see part 10, Art. Xll of the Code of Civil Procedure for all other exemptions of personal property from judgment enforcement).
16. Borin v. John Hancock Mutual Insurance Company et al, 21 Ill. App. 2d 139; 157 N.E.2d 673 (1959).
17.
18. See Mario A. Mata, Use of Domestic Family Limited Partnerships and Limited Liability Companies in Asset Protection Planning, in Asset Protection Strategies, Planning with Domestic and Offshore Entities, ABA Section on Real Property, Probate and Trust Law (Alexander A. Bove, Jr. ed. 2002) pp. 105-1 10 (2002).
19. 805 ILCS 180130-20(e); Jeffrey M. Goldberq & Assocs., Ltd. v. Holstein (In re Holstein), 299 B.R. 211 (Bankr. N.D. Ill., 2003).
20. See generally Asset Protection Strategies, Planning with Domestic and Offshore Entities, ABA Section on Real Property, Probate and Trust Law (Alexander A. Bove, Jr. ed. 2002) pp. 105-110 (2002).
21. See Restatement of the Law, Second, Trusts, §156, The American Law Institute (1959).
22. See Gideon Rothschild, Chapter 16: Protecting the Estate from In-Laws & Other Predators, 35th Annual University of Miami School of Law Philip E. Heckerling Institute, p. 16-9 et seq. (2001).
23. See generally, Asset Protection Strategies, Planning with Domestic and Offshore Entities, ABA Section on Real Property, Probate and Trust Law (Alexander A. Bove, Jr. ed. 2002) pp. 105-1 10 (2002).
24. See Richard W. Nenno, Relieving Your Situs Headache: Choosing and Rechoosing the Jurisdiction for a Trust, 40 University of Miami Philip E. Heckerling Institute, p. 3-73 and 3-109, 110 (2006).
25. For a comprehensive analysis of DAPTs, see Richard W. Nenno, Domestic Asset Protection Trust Comes of Age, 38 University of Miami Philip E. Heckerling Institute (2004).
26. Drye et al. v. United States, 528 U.S. 49; 120 S. Ct. 474; 145 L. Ed. 2d 466 (1999).
When we think of the potential liability of a parent corporation for the acts of its subsidiary, we normally think of the situation in which the corporate veil of a subsidiary is sought to be pierced in order to hold the parent liable. In order to pierce the veil of the subsidiary, it is normally necessary to show that the subsidiary was undercapitalized or that corporate rituals were not followed so as to be able to distinguish the separate existence of the parent and the subsidiary. But what if the subsidiary is adequately capitalized and corporate rituals are followed. In this situation there is another theory on which a parent corporation can be liable in a parent-subsidiary context. This is the “direct participant” theory of liability in which the parent is liable, not because the separate existence of the subsidiary is disregarded but rather because of the parent’s own actions.
Such an approach to liability makes legal sense. Since an individual can form a corporation and be protected from personal liability based upon the entity’s liabilities, it arguably follows that a corporation could form a subsidiary and be shielded from the liabilities of such entity. On the other hand, it is well settled that when a individual who has formed a corporation performs a wrongful deed, such individual is not protected by having formed a corporation. When a shareholder actively participates in the wrongful conduct of a corporation, the shareholder will be personally liable for such “active participation.”1
It logically follows that, if an individual shareholder can be personally liable when the shareholder actively participates in the wrongdoing, so also should a parent corporation be personally liable when it actively participates in the wrongdoing of its subsidiary. A corporate parent should have no more insulation from liability than should an individual shareholder. In fact, since the individual shareholders of the parent still retain insulation from liability, a fortiorari, the parent should be liable when it actively participates in the wrongdoing. This is the essence of the “direct participation” theory.
Justice (then professor) William O. Douglas, in his seminal article on parent/subsidiary liability, observed that. “[t]here is a group of cases where liability is imposed upon the parent for torts of the subsidiary”2 even though the traditional grounds for ignoring the separate existence of the subsidiary were not met.3 According to Justice Douglas:
[This would occur in] instances were the parent is directly a participant in the wrong complained of. The parent has been held liable in a tort action for inducing the subsidiary by means of its own stock ownership to breach a contract with the plaintiff. Stock ownership was not enough. But the use of the latent power incident to stock ownership to accomplish a specific result made the parent a participator in or doer of the act. Again, there was interference in the internal management of the subsidiary; an overriding of the discretion of the managers of the subsidiary.4
The “direct participant” theory was recently recognized by the U.S. Supreme Court, in U.S. v. Best Foods,5 and by the Seventh Circuit, in Esmark Inc. v. NLRB.6
The direct participation doctrine was relied upon by the court in Forsythe v. Clark USA, Inc.,7 a case brought by the estates of two employees of Clark Refining who were burned to death when other employees attempted to replace a valve on an Isomax unit without insuring that flammable materials within the pipe had been depressurized. The employees who sought to replace the valve were not maintenance employees and were not trained or qualified to do the work in question. Plaintiffs alleged that defendant Clark USA (the parent) breached its duty to plaintiff by:
(1) “requiring [Clark Refining] to minimize operating costs including costs for training, maintenance, supervision and safety.” (2) “requiring [Clark Refining] to limit capital investments to those which would generate cash for the refinery thereby preventing [Clark Refining] from adequately reinforcing the walls of the lunch room or relocating the lunch room to safe position within the refinery,” and (3) “failing to adequately evaluate the safety and training procedures in place at the Blue Island Refinery.”8
Plaintiffs relied on the following evidence:
[D]efendant’s directors drew up and approved Clark Refining’s budget; the boards of both defendant and Clark Refining often met simultaneously; according to defendant’s 1995 strategic business plan, defendant mandated that Clark Refining “position itself as a low cost refiner and marketer”;9
Defendant argued that “as a mere holding company where the only connection to Clark Refining was its status as sole shareholder, it owed no duty to either deceased.”10 It further argued it had no control over day to day operations. However, the primary role of a shareholder is to elect directors and then to let the directors manage the corporation. Adopting a budget is a function of the board of directors of the subsidiary, not the parent shareholder. It is also up to the board of directors of the subsidiary to determine capital expenditures and staffing levels, not the parent shareholder. Accordingly, when the parent shareholder usurps the role of the board of directors of the subsidiary, it then assumes responsibility for the consequences of its actions.
While courts have recognized that the mere fact that the board of the parent and the board of the subsidiary overlap is not a basis for piercing the corporate veil of the subsidiary, a parent takes such action at its own risk. When there is an identity of directors, it is difficult to determine in whose interest the directors are acting; in fact, the presumption should be that they are acting in the best interest of the parent. The individuals in question are not directors of the parent because they are directors of the subsidiary; rather they are directors of the subsidiary because they are directors of the parent!
According to the dissent, “plaintiff have not presented sufficient evidence to overcome the presumption that the director wore their ‘subsidiary hats’ and not their ‘parent hats’ when making the decision that allegedly led to the injuries here.”11 But, as stated above, such a presumption is irrational. The directors are directors of the subsidiary because they are directors of the parent, not vice versa. The purpose of having them serve as director of the subsidiary is to enable the parent to exercise additional control over the subsidiary. As the United States Supreme Court stated, in Consolidated Rock Products Co. v. DuBois:
It is well settled that where a holding company directly intervenes in the management of its subsidiaries so as to treat them as mere departments of its own enterprise, it is responsible for the obligations of those subsidiaries incurred or arising during its management ... A holding company which assumes to treat the properties of its subsidiaries as its own cannot take the benefits of direct management without the burdens.12
The loyalties of persons who are directors of both the parent corporation and its subsidiary is illustrated by the case of Weinberger v. UOP, Inc, 457 A. 2d 701 (Del. 1983), where directors who sat on both boards utilized information that they received as members of the subsidiary in connection with a study they did for the parent to determine how much the parent would offer to buy out the remaining shareholders of the subsidiary. The study was disclosed neither to the members of the board of the subsidiary who were not connected to the parent nor to the minority shareholders of the subsidiary.
In addition to overlapping directors, Paul Melnuk was both president of defendant Clark USA and CEO of Clark Refining. According to the dissent, “[m]ost notably, plaintiffs have not alleged any negligent acts committed by persons who served solely as officers of defendant and not also as officers or directors of Clark Refining.13 In effect, the dissent has the cart before the house. There is no requirements that the parent have its president also serve as CEO of the subsidiary. Similar to the director situation, the presumption should not be that the person in question is acting for the best interests of the subsidiary, rather than this best interest of the parent. Rather, the opposite is generally the case. If the president had a choice, would it be better for the parent to fail or for the subsidiary to fail. Obviously, the executive’s first loyalty is to the parent. If the parent goes down, the overall entity is lost. If the subsidiary fails, only a piece of the overall entity is lost.
This is illustrated by the facts in Clark USA. The defendant strove to “replenish the strategic cash reserve [of defendant] to $200 million” by “decreas[ing] capital spending *** to minimum sustainable levels” and instituting a “survival mode” philosophy to its 1995 business plan.14 The desire to generate cash was for the benefit of the parent, not the subsidiary. When Melnucks, the president of Clark USA and CEO of Clark Refining, instructed the employees of Clark Refining to reduce the budget they proposed by 25 percent, he was acting in the best interests of Clark USA (by building up its cash reserve), not in the best interests of Clark Refining (which had its capital budget decreased and suffered “a series of cutbacks at the Blue Island refinery that undermined safety, training, maintenance there and, in turn, created an unreasonable risk of harm to others including the employees of Clark Refining.15
Consequently, when Clark USA “directly intervene[d] in the management of its subsidiaries so as to treat them as mere departments of its own enterprise,”16 it became liable for the consequences of its actions.
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This article was adapted from 7 Murdock, Illinois Practice – Business organizations 6.19A “Direct Participant” Liability for a Parent Corporation
1. See infra § 8.22
2. Douglas and Shanks, Insulation from Liability through Subsidiary Corporations,” 39 Yale L.J. 193, 205 (1929).
3. For example, undercapitalization and commingling if funds are frequently found when a court pierces the corporate veil; controversial, adequate militate against piercing the corporate veil. See infra §8.19. On the other hand, adequate capitalization of the subsidiary would be irrelevant when the parent corporation is guilty of direct participation in the wrongdoing.
4. Id. At 208-209
5. 524 U.S. 51, 61 (1998)
6. 887 F. 2d 739, 755 (7th Cur. 1989)
7. 836 N.S. 2d 850 (2005)
8. Id. at 852
9. Id. at 853
10. Id. at 852
11. Id. at 862
13. 836 N.E. 2d at 863
14. Id. at 853
15.Id.
16. Consolidated Rock Products, 312 U.S. at 510.