Protecting Corporate Assets From Liability Risks
We must also consider the issue of protecting the assets of the corporation. The corporation, as an entity operating a business, is in the front line of attack for litigation from every conceivable source. If the company loses a lawsuit, all of its assets are available for collection. Because of this, a sensible asset protection strategy must be adopted for the corporation as well as for the individual. As a rule, to the extent practical, you do not want the corporation to hold any significant assets. You do not want a corporation to build up a substantial net worth only to see everything wiped out in the event of a lawsuit.
Real Estate and Equipment
Assets, such as real estate and equipment, should never be held by the corporation. These assets should be held by another entity-a Family Limited Partnership, LLC, or a trust-and leased back to the corporation at a reasonable rent. Since the property will be leased, rather than owned, the assets will not be available for collection by a creditor of the corporation.
The corporation should never hold any surplus cash. Only amounts necessary to pay immediate and foreseeable obligations should remain in the corporate account. Any surplus should be loaned or paid out as salary or some other type of distribution. The last thing you want is a fat pile of cash available for the taking
Inventory & Account Receivable
Certain types of property can’t be conveniently held outside of the corporation. Assets, such as inventory and accounts receivable, will undoubtedly cause tax and accounting difficulties, unless they are maintained in corporate form. If these types of assets are significant in value, one solution is to create liens which will have priority over subsequent creditors. For example, the owners of a business or professional practice can make loans to the corporation for working capital or other needs. As security for these advances, the corporation can give the owners, as collateral, a lien on corporate inventory and receivables. This security interest is called a UCC-1 filing under the provisions of the Uniform Commercial Code (UCC). The hoped for result of this UCC-1 filing is that the inventory and receivables will be protected. A judgment creditor would find that the equity in these assets is subject to the superior claim of the business owners and cannot be used to satisfy the judgment.
Trademarks, patents, and copyrights are valuable assets which should not be owned directly by the operating entity. A separate company can own these assets and make them available through a form of a licensing agreement. The objective is to protect these assets in the event of a judgment against the corporation.
One of our clients was in the garment manufacturing business. His company sold primarily to the large department stores. This is always a dangerous business. A large amount of capital is needed to fill orders which are not paid until sixty or ninety days after shipment. A common scenario goes like this: An unusually large order is placed by a retailer, and the manufacturer uses all of its cash and credit to buy the materials and pay the workers to fill and ship the order. Then, ninety days later, before the manufacturer has gotten paid, the truck pulls up with the entire order returned. Since the value of the goods to the manufacturer is only a fraction of the invoice amount, the manufacturer is now out of business since it is out of cash and out of credit. The bankruptcy court and the creditors now attempt to seize and sell every asset of the company including any valuable trademark or trade name.
Our client engaged in the proper planning before these events took place. The trademark and the trade name were owned by a separate company. The new company (NewCo) then licensed the use of these properties to the corporation on a monthly basis. When the corporation ultimately filed for bankruptcy (because of the circumstances we just described), the trademark and trade name were safely protected in NewCo. Since it was these assets which contained all of the goodwill of the business, our client was able to successfully go back into business and establish a new company.
Using Multiple Corporations and Special Purpose Vehicles
Whenever feasible, assets, such as real estate and equipment, surplus cash, inventory, accounts receivable, and intellectual property should not be held by the operating corporation.
If the business of the corporation can be divided into separate businesses, both assets and liabilities can be protected or managed through the use of multiple entities, (which may be corporations, LLCs, limited partnerships, or trusts—all of which together are referred to as Special Purpose Vehicles or SPVs). We have seen many abuses of these strategies in now infamous corporate scandals. Enron used multiple corporations and SPVs to remove liabilities from its corporate balance sheet and to disguise its growing losses from investors and regulators. Lehman Brothers, in the years preceding its bankruptcy, and apparently many of the large banks, still regularly shift liabilities to SPVs prior to the end of a fiscal quarter, which effectively overstates the company’s financial strength. Despite these past and certainly ongoing abuses, SPVs allow us to accomplish many legitimate business and legal objectives. In one form or another, most businesses with valuable assets or revenues to protect use multiple corporations or SPVs for structuring flexible financing, issuing securities to investors, and achieving enhanced legal liability protection.
The simplest example of the usefulness of SPVs is a corporation with more than one retail outlet within a single corporation. If business at one of the locations slows down substantially, that outlet may became a financial drain on the others, absorbing all of the available cash in the company. At a minimum, our approach in these situations is to have each store location be separately incorporated. Then, if one were to falter, the liabilities would not drag down the other, still valuable, stores. A judgment creditor of one corporation would not be able to reach the assets of the other companies. An extreme illustration of this is the taxicab company which separately incorporated twenty-six different taxis.
This strategy is also useful for a company that manufactures or wholesales different product lines. Companies in the pharmaceutical business face enormous potential liability for many types of drugs and medical devices. Whenever a particular product may be hazardous, using multiple corporations (or other entities) is a popular legal strategy for insulating each separate product from liability caused by another.