The Wall Street Journal recently ran an article about how, when small businesses are forced to file for bankruptcy protection, the inevitable result is that it usually takes the owners down with it. This is extremely common, and far more frequently the rule than the exception.

Why does this happen? Why, if the proprietor has gone through the expense and trouble to create a corporation or a limited liability company (“LLC”) do these things wind up being just so much superfluous window dressing right at the moment when you really need them to step up and do their job?  (Their job being to protect your assets when things go sour.)  Because the corporation or limited liability company formed for the needs of the of the small business owner usually doesn’t have adequate assets or resources to give any comfort to creditors–bank lenders most commonly–and so the lender wants as much security for the loans as possible. Enter the concept of the personal guaranty.

If ABC Corp. wants to borrow $1 million for an operating loan but only has assets of $50k of office furniture, computers, fixtures, etc., the bank is going to want some other security. And if ABC Corp’s sole shareholder has a few hundred thousand dollars in equity in his home, then the bank is going to want a security interest in that. Plus whatever else the owner may own. So the bank demands a personal guaranty from owner, which are usually so broad in what they cover that they renders the entire concept of the LLC or the corporation almost completely useless. And it happens with such efficient thoroughness and with such frequency, that it’s probably safe to say that if a personal guaranty is involved, then don’t even bother with the corporation or LLC. (Except maybe for tax or accounting purposes but we won’t go into that here.)

Another place where this pops up is in the single purpose LLC formed for the purpose of owning real property. I have taken quite a few people through Chapter 7s recently who had a bunch of LLC’s (or the increasingly popular Delaware “Series LLC”) that had been formed to own real estate. The problem is that banks won’t lend money for investment real estate to an LLC on the same terms that then will lend for owner-occupied residential property. They usually want 30% to 40% down depending on the asset. Why? Because the bank wants the owner to have “skin” in the game so that he won’t walk away.

So here’s what happens.  (Or what was happening until things crashed in 2007.)

California resident finds great deal on 3br new construction home in Anytown, Utah (for example only). His real estate broker hooks him up with a loan broker to line up the financing. Owner has nothing to put down, and has read somewhere that investment real estate should be owned by an LLC to “protect his assets.” So Owner goes out and pays some lawyer $1,500 to form a fancy “Delaware Series LLC” for the purpose of owning the investment real estate in Utah. But here’s where the fancy plan derails: Bank won’t lend100% to an LLC, and the loan broker is usually too 1.) greedy 2.) stupid 3.) dishonest 4.) clueless to properly advise Owner. So Owner gets the stack of loan docs, all of which show that it is Owner as an individual, not Owner’s Delaware Series LLC that is the actual borrower on the loan.  Deal closes and Owner gets his house. At this point Owner may transfer title to the LLC in the misguided belief that he is actually using this fancy legal device that he paid the lawyer $1,500 to create for him. After that Owner installs tenant, hires management service, and sits back to starts to collect the rent.

Things go great until 2007 or 2008 when the when the world comes crashing down. The house that Owner bought for $265,000 is now worth about $200,000 or less, the tenants have moved out, and because of the crash in housing prices, Owner can’t rent the property for enough to cash flow the loan, taxes and other expenses. Owner is now officially upside down (or under water) and is having to send checks form California every month just to meet the expenses. So Owner goes to a new lawyer. In many cases, this is me.

Here’s the situation:

1.     At this point, the LLC is completely irrelevant. It is nothing but a concept and if Owner has to file Chapter 7, it will be a worthless asset in that proceeding. Why? Because it doesn’t own anything of value. It has been deeded a property worth $200,000, which is subject to a first deed of trust for $275,000.

2.  The LLC offers no protection from anything at all to Owner. Why? Because Bank didn’t lend money to the LLC, it lent it to Owner. Owner signed the Loan docs, not the LLC. Bank doesn’t give a hoot about any LLC; its deal is with Owner and its security is Owner’s real estate. Yes, in our hypothetical Owner deeded the property to the LLC but read the loan documents!!! That doesn’t remove Owner from being on the hook for the loan. Owner can’t–after the loan is made–unilaterally change the loan terms to isolate himself from liability by deeding the security to another entity.

(People do this all the time by the way. It happens in divorces, partnership break-ups, DIY estate planning attempts, etc. Here’s the rule: You can’t change the terms of a real estate loan by deeding the property away. Ever. It can’t happen. Once lender and borrower get into a deal, and Lender records its security, nothing the borrower can do can ever change the terms of the loan without the lender’s written consent. Is that clear enough?)

So where is Owner now? Well, if the state in which the real estate is located allows Bank to pursue a deficiency after foreclosure, then Owner is up a creek. Bank will take the property back in foreclosure, sell it and come after Owner for whatever may still be owing on the loan. It has been shown that it costs most lenders about $60,000 to foreclose on real property (see article “Freddie Mac Says Typical Foreclosure Costs 60,000 Dollars“).

Since in our hypothetical, the property is worth $200,000 at the time of the default, Bank will recoup about $140,000 net of foreclosure expenses, leaving a deficiency of $135,000 plus whatever interest has accrued since default which Bank is going to expect Owner/Borrower to pay. The LLC will not protect Owner from this at all, and Owner’s only choice is to write a check or file personal bankruptcy.

Was this avoidable? Yes. Completely. The moral? Pick your advisors carefully and make sure YOU understand the nature of the legal relationships YOU’RE getting into before YOU get into them.

And don’t believe everything you read. I wouldn’t even believe half of everything you read. Especially if someone is trying to sell you some snake oil in the form of a Delaware Series LLC, or a Nevada Corporation, or an International Asset Protection Trust, or anything at all that promises to insulate you from personal liability for the consequences of your business relationships.

Most of that nonsense you read on line is just that: Nonsense. Hire a real business lawyer to reverse engineer the end result you want. It’s not rocket science; it’s just law.

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