Asset protection planning is something that is heavily marketed. It is also heavily marketed in many of the wrong ways. One of the worst ways that asset protection is marketed is that creditors will see asset protection planning and run away. Not even try to sue.
It doesn’t work that way at all. In the real world, creditors are positively pleased to see asset protection planning because it means the debtor has assets. But also in the real world, asset protection plans are only very rarely challenged by creditors. There is a practical reason for this and understanding it will help you understand the proper role of asset protection planning. It is the last of four lines of defense.
First Line Of Defense: Risk Management
Events giving rise to liability can sometimes be avoided altogether through risk management. Business organizations, for example, typically devote substantial resources to risk management. Individuals can also benefit from risk management. The first task is to inventory potential sources of liability. For example, are you letting a family member with a drinking problem use your car? Not a good idea, since if they are out driving under the influence and injury somebody then you could be held liable for negligent entrustment of the car. Better to make them a personal loan and let them buy their own car with title in their own name.
A common place where this comes up is where you have rental properties and are managing them yourself. If the water heater is leaking and the staircase seems to have rotted, but you defer maintenance because you think it will safely last a while longer, then you could be personally liable as the property manager if the water heater explodes or the stairs collapse. Even if the property is held in an LLC, the property manager will be personally liable for their personal negligence. Better to hire a property management company who take on this liability even if it costs more.
Another place where there can be an opportunity for risk management is personal guarantees. Yet, most borrowers don’t even try to manage their personal guarantee risk. The deal is great and is going to make everybody a lot of money so why bother? But deals fail. Crashes occur. Guarantees get called. Best to avoid them altogether whenever possible. Sometimes it is possible to obtain project financing by posting additional collateral and paying a slightly higher interest rate. Where that is possible, it is always preferable to entering into a personal guarantee. It is also sometimes possible to negotiate limits personal guarantees to some set amount that at least cuts the guarantee liability down to a finite amount. Or, at the very least, set aside assets that can be liquidated to satisfy the guarantee even if that means that some assets will not be fully deployed to gain additional leverage.
All of this is to say that where liabilities are involved, don’t be penny wise and pound foolish. If you can pay a little bit and avoid liability altogether, that will usually be a good deal. People don’t really get sued out of the blue. They get sued because they made some mistake and it was usually a mistake that they could have avoided with just a little bit of forethought. Precisely that forethought is what personal risk management is all about.
Second Line Of Defense: Liability Insurance
If risk management fails and a liability arises, hopefully it will be taken care of by liability insurance. There is nothing better than to be able to tell your insurance adjuster, “Here’s my check for my $5,000 deductible, now it is your problem.”
A problem here is that folks are typically underinsured and sometimes woefully underinsured. The most common example of this is insurance against vehicular liability. Many people have only the statutory minimum amount of insurance required by the state, say $50,000 or $100,000 in coverage. Consider that if one gets into a serious accident where multiple victims go to the ICU for any considerable period of time, the medical bills alone could go deep into six figures.
Or, a person may not be insured at all against significant liability risks and simply not realize it. Let’s say that they hire a nanny who later sues for an abusive workplace environment. Unless they have an employer liability policy, the claim will probably not be covered by other insurance.
These situations usually arise because there has been a failure to sit down with a liability insurance broker periodically and fully examine possible liabilities and whether coverage amounts are reasonably high enough to cover likely claims. What happens in real life is that insurance will be required for some amount but this amount doesn’t increase as the policy is annually renewed. After five or ten years, the policy limits become inadequate.
Although umbrella insurance is far from perfect ― for instance, intentional acts are generally excluded ― umbrella insurance can provide much larger coverage amounts for things already covered by other policies with lower limits. Umbrella insurance can also close coverage gaps in existing policies.
Before spending money on asset protection planning, money should be spent on greater insurance coverage. Indeed, a lot of folks will be perfectly fine with nothing but insurance coverage. The idea sometimes asserted by promoters that asset protection planning can allow a person to decrease their insurance coverage is false.
Third Line Of Defense: Litigation Defense
If insurance doesn’t cover a liability, then litigation over the liability will likely occur. That means that the litigation will have to be defended, which can be expensive. The best scenario is to win the litigation but that usually means gambling before a jury. The worst scenario is to spend a lot of money litigating the case and then still lose.
Trials occur because one party (or sometimes both) has made a mistake. That mistake was in correctly “pricing the case”. Every case has a value, which is determined by the likely amount of recovery or exposure as adjusted by the likely chance or winning or losing ― plus the attorney fees, expenses and costs to get the case over the finish line. There is no methodology which precisely calculates this number, but good trial attorneys can usually get within the ballpark based on their past experiences with similar cases. If both sides correctly price the case, then it should settle well before trial. Again, the case only goes to trial if at least one party has mispriced the case.
Otherwise stated, when a case goes to trial both parties believe that they will prevail. They cannot both be right. One party is wrong, and that party is making a serious mistake. We know this result with perfect hindsight ― the party that won was right and the party that lost was wrong.
Even if a party is certain that it will prevail, there is also the uncertainty of juries. Weird things happen with juries who are nothing more than ordinary folks who are like the rest of us who have been thrust into deciding the outcome of a dispute that they would rather not decide. So, with both sides there is always a risk that the jury will tilt in an unfavorable direction. For what it is worth, my view based on experience is that arbitrators are even more likely than a jury to go off the rails.
Thus, cases settle because the parties agree on the price of the case and both parties desire to avoid the uncertainty of trial and future litigation costs.
This brings us to the next best scenario: The case settles early. If one is a defendant facing a liability, the best chance to get out of the litigation at the best price will be at the onset of litigation, before either side has incurred much in the way of legal fees and related expenses. As litigation drags on, the plaintiff will necessarily require a higher settlement amount to compensate for the fees incurred so far and this will make the case more difficult to settle.
What I am getting around to in all this is that one should have a litigation strategy designed to settle the case as quickly as possible. This also means that one should built up a fund by which to pay a settlement if the opportunity presents. This also goes for so-called “excess claims” which are claims in excess of insurance coverage. Often, one can avoid excess liability by paying some money early as the plaintiff’s attorney will be focused on hitting the full amount of the insurance policy.
The bottom line is that litigation must be managed and an attempt made to settle the case early if possible.
Fourth Line Of Defense: Asset Protection Planning
If everything else fails, then you finally get to asset protection planning. A discussion of what asset protection entails is well beyond the scope of this article, but the point is that asset protection is the last line of defense. Not the first, second or even third lines, but the fourth and last. Asset protection is what hopefully will protect at least some minimal amount of assets if everything else goes South.
Anecdotally, less than 1% of asset protection plans are ever challenged by creditors. The reason for this low rate is that asset protection stands behind these three other lines of defense. Most cases will be resolved one way or the other and will end without a judgment being entered against a debtor with an asset protection plan.
In those rare cases where asset protection plans are challenged by creditors, it was because the debtor made a very serious mistake in at least one ― and possibly all ― of the previous three lines of defense. The debtor made a mistake to incur the liability, the liability was not covered by adequate insurance, and no settlement was achieved in litigation. Of these, most of the mistakes were in incurring the liability in the first place, with probably at least a third of them being from personal guarantees being called.
If you want to look at it another way, something like 99 out of 100 people who created asset protection plans in the end didn’t need them. If they had done nothing in the way of asset protection planning, they would not have come out any worse. This really isn’t much different than insurance: Out of 100 drivers who purchase auto insurance in a given year, only a very small percentage of those drivers will have an accident. And that’s kind of the way that folks should view asset protection planning, which is as a form of insurance. It makes sense for folks who have enough assets that they will need to engage in substantial estate planning anyway, since these folks can often build considerable asset protection in to the estate planning structures that they were going to utilize anyway.
But that also means that a large number of folks who don’t have so many assets might be better off spending their dollars on risk management and insurance. Making this call can sometimes be a tough decision and of course everybody is different and has different circumstances.
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