Asset Protection for Corporate Officers & Directors

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The 2005 Bankruptcy Reforms:

Salt Into the Wound of Sarbanes-Oxley

The Sarbanes-Oxley Act of 2002 dramatically expanded the duties and responsibilities and the potential liabilities of corporate officers and directors. The new Act introduced strict rules relating to conflicts of interests, such as personal loans for directors. Sarbanes-Oxley also requires corporate officers and directors to make certain reports and disclosures relating to internal controls. Additionally, the Statute of Limitations for securities fraud was expanded to the longer of five years or two years from disclosure of the fraud, and whistleblowers have greatly expanded protection as well as a right to sue for special damages.

There were no shortages of securities class-action lawsuits even prior to Sarbanes-Oxley, but after its passage, litigation became much more personal, especially for outside directors. To settle their liability on the accounting fraud claims alone, ten outside directors of WorldCom agreed to pay $18 million from their personal assets, which represented an estimated 20% of their net worth. Another $36 million was paid from their D&O insurance. Similarly, ten former Enron directors agreed to personally pay $13 million as part of a $168 million settlement for fraudulent accounting practices.

Stung by large claims against the D&O policies issued to these unfortunate directors, the insurance carriers have tightened up their policies and expanded their exclusions. Future corporate officers and directors who are caught up in similar circumstances may have to litigate with their own insurance carriers to provide defense and coverage. Also, a sustained series of financial collapses, such as the savings & loans crisis of the 1980’s, might challenge the solvency of a particular insurance carrier and its ability to timely pay claims.

Corporate officers and directors now face the specter of personal liability unrecompensed by their company or its insurance carrier for shareholder losses, whistleblower claims, and similar types of liabilities. Such liability in the past would have been met with personal bankruptcy. Or, with little foresight or strategy, a person expecting difficulties could simply move to Texas or Florida, where the creditor exemption for homestead was unlimited. It was also easy for corporate officers to load millions into their ERISA-protected pension plans knowing that they would be protected from any future creditors as well.

Not any more.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 appears to specifically target corporate officers and directors so that they will not be able to protect any significant assets in bankruptcy. While the new Bankruptcy Act significantly pared down the exemptions available to all debtors, it virtually eliminates any meaningful protection for those who are successfully sued for securities fraud or breach of fiduciary duty.

The key provision is the new section 522(q), which limits any exemption existing under State law to $125,000 for several types of debts including those arising from:

(i) any violation of the Federal securities laws (as defined in section 3(a)(47) of the Securities Exchange Act of 1934), any State securities laws, or any regulation or order issued under Federal securities laws or State securities laws;

(ii) fraud, deceit, or manipulation in a fiduciary capacity or in connection with the purchase or sale of any security registered under section 12 or 15(d) of the Securities Exchange Act of 1934 or under section 6 of the Securities Act of 1933; and,

(iii) any civil remedy under section 1964 of title 18 (this is the civil RICO remedy provision).

These are, of course, three of the most common avenues to the personal liability of a corporate officer or director. For persons who are successfully sued under one of these theories, the effect is that they will not be able to protect more than $125,000 in their house, regardless of how much the state allows, nor will they be able to protect more than $125,000 in their pension or similar types of retirement plans. In other words, if you are successfully sued for securities fraud, breach of fiduciary duty or civil RICO, you will not be able to protect much more than 250,000 in your combined home and retirement plans, and a few personal effects.

If all this isn’t bad enough, prospective debtors are also limited in the type of pre-bankruptcy planning that they can do. A new section 522(o) creates a 10-year period during which the bankruptcy trustee can claw back non-exempt assets that were converted to exempt assets to avoid creditors. Other provisions of the new Bankruptcy Act create numerous other limitations for debtors to protect assets.

So how about those asset protection trusts that you read about all the time? Form one in the Cook Islands, or even in Alaska or Delaware these days, and your assets in them will be bulletproof from creditor claims, right?

Wrong.

Stung by criticism in a New York Times article about a “loophole for the rich” in the new Bankruptcy Act, Congress passed a new section 548(e) that allows a bankruptcy trustee to clawback assets that were transferred to an asset protection trust within ten years of the filing of the voluntary or involuntary bankruptcy petition, if the transfer was meant to diminish the rights of creditors. Since the very purpose of an asset protection trust is to diminish the rights of creditors, the import is that assets transferred to such trusts can be easily backed out by the bankruptcy trustee.

The new 548(e) not only applies to asset protection trusts, which are self-settled trusts that one creates for his own benefit, but also applied to “like devices”. Congress did not attempt to define “like devices,” but one could reasonably infer that it is anything that has a specific purpose for protecting assets while allowing the person who created the structure to have the beneficial use of those assets.

Congress did not need to worry about asset protection trusts. The bankruptcy courts had never respected them anyway, and in a series of cases the courts simply treated the assets in such trusts as part of the bankruptcy estate. In one case, involving former derivatives trader Stephen J. Lawrence, the court ordered him to provide information relating to his offshore trust and when he refused, the court cast him into prison for contempt. Lawrence went into jail in August of 2000, and was still in the pokey as of the writing of this article.

The truth is that foreign asset protection trusts have a chance of working if you flee the jurisdiction of the U.S. courts when things get dicey. Of course, doing that may cause your other creditor protections, such as homestead, to dissolve, and you may be precluded from defending the claims against you under what is known as the “fugitive disentitlement doctrine”. The new Domestic Asset Protection Trusts that are heavily marketed by trust companies based in Alaska, Delaware and a few other states have little chance of protecting assets under the new 548(e).

To make doubly sure that corporate officers and directors could not hide their wealth in asset protection trusts, Congress specifically mandated that in interpreting 548(e) “a transfer includes a transfer made in anticipation of any money judgment, settlement, civil penalty, equitable order, or criminal fine incurred by, or which the debtor believed would be incurred by” a violation of the securities fraud and securities registration laws. While this language seems redundant, it sends a clear message: Persons active in the securities industry should be personally liable for their decisions, and this liability should not be defeated by asset protection subterfuges.

So what does work?

There is an old adage that “As the laws get tighter, the lawyers get smarter.” Asset protection will not go away, but it will necessarily become more complex and sophisticated to meet such evolutions in debtor-creditor law as the new Bankruptcy Act.

It is important is to keep assets off of the personal balance sheet, so that if there is a bankruptcy the assets will not show up in either the debtor’s schedules or in any recent history of past transactions. This can be legally accomplished through sophisticated estate and business planning done well in advance of any potential creditor problems.

Estate planning is a legitimate form of personal planning that does not by itself raise unnecessary suspicions of anti-creditor planning. While the new Act makes clear that one cannot create a trust for one’s own benefit and still hope that the assets will be protected from creditors, it did not impact ordinary, non-self-settled trusts at all. One can still, for instance, create a trust for one’s children or grandchildren and convey valuable assets to that trust. So long as it is done at least several years before problems arise, both the transfer and the trust should be respected and stand-up even in bankruptcy.

The key to making estate planning perform an asset protection function is to avoid utilizing gifts as the method of transferring assets to the trust. Gifts by their very nature are without reasonably equivalent value and, thus, are susceptible to being set aside as fraudulent transfers. Instead, for-value transfers such as self-canceling installment notes and private annuities should be utilized for transfers. While these transfers are much more complicated from a tax perspective, they are much safer from a debtor-creditor law perspective.

Business planning can also have the effect of moving assets off of the future debtor’s balance sheet and into an entity where a creditor will have a difficult time accessing them to pay a judgment. By contributing assets to a limited partnership, the assets are effectively transformed from a form that is easy for creditors to collect upon into partnership interests against which a creditor will be limited to a charging order that restricts the creditor’s rights to receiving the distributions that the debtor would have normally received. Of course, if no distributions are made to the debtor’s interests, the creditor gets no distributions either, and the case law has, with only rare exceptions, protected the valuable assets within the limited partnership from creditors’ collection attempts.

Future strategies may involve the creative use of life insurance and annuities in the numerous states that offer substantial levels of protection to those products when properly structured and drafted. Although Congress eviscerated some of the most common forms of debtor planning, it did not seek to change the existing state exemptions for those products, although they will still be potentially subject to the ten-year limitations period for the conversion of non-exempt assets into exempt assets. However, by combining sophisticated forms of insurance with certain forms of ERISA planning, plans could be created that would offer formidable barriers to even the most sophisticated creditors.

An important factor in asset protection planning has always been to do the planning well in advance of creditors. Prior to the new Bankruptcy Act, the required amount of time for a debtor to reach a degree of comfort that transfers would not be reversed was sometimes measured in months, or, at worst, a couple of years. Future asset protection planning will require much greater foresight and passage of time before the same levels of comfort can be achieved. In other words, if you want protection that will have a chance of standing up, you need to start that planning as soon as possible in the hope that some significant water will pass under the bridge before it is challenged.

A final word of advice is to avoid those asset protection solutions that are heavily marketed. Such solutions will not escape the notice of creditors, who may attempt to lobby Congress for additional changes to the bankruptcy code so as to mitigate the effects of those solutions. Instead, seek personalized solutions that have substantial purposes not ordinarily related to asset protection, but which have the effect of challenging those assets unpalatable to creditors. The best asset protection plan is one that is so subtle that it cannot be readily identified by creditors or by the court as an asset protection plan.

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This website is by far the largest and most comprehensive creditor-debtor and asset protection resource available anywhere. This website hosts thousands of pages of articles, cases, statutes, analysis, and many other resources to assist planners and judgment collection professionals in researching contemporary creditor-debtor issues.

While the articles and analysis on this website are most often drafted from a planner's point of view, creditor attorneys and judgment collection professionals will also find many of these resources to be highly useful. We have tried whenever possible to be balanced in our analysis by pointing out strengths and weaknesses in different structures and strategies from both the planner's and creditor's viewpoint.

This website was primarily created to support our book Asset Protection: Concepts and Strategies (McGraw-Hill 2004). Because of the publishing agreement with McGraw-Hill Companies, Inc., certain articles which were used as the basis for that book have been withdrawn from internet publication. It is suggested that the book be used as the primary resource, and that the other materials on this website should be used as supporting materials only as needed.

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