Creditor Proofing is arranging your financial affairs to protect your assets against unreasonable acts by creditors. It will rarely give you absolute protection.
Few things in life are 100% certain. Creditor Proofing is not a way to cheat your creditors. It is a logical business process. Institutions that make loans to you protect their interests by trying to tie up your assets so they can get at them quickly if you run into trouble.
It makes sense to us that you would choose what you risk and have some control over what happens if you do run into trouble. Creditor protection can limit your risk and give you time to work things out.
What can it give you?
Some protection for some of your assets if you hit a disaster.
Some protection for your family against arbitrary decisions by creditors.
Negotiating power and time if you run into trouble.
Limits on the amount you gamble when you do a deal or make an investment.
It is always a compromise between the amount of protection you could have vs:
Your freedom to finance expansion in your business or investments;
The extra legal and accounting fees;
Your loss of flexibility in use of assets;
Your loss of absolute control or ownership of assets;
Having to involve other family members in your decisions;
The hassle – you have to update your planning regularly.
Look back to when you started your business. Life was simple. Maybe you did not have much to lose! Today, you are older and wealthier and it is not as easy to start again. Consider your risks:
As a PROPRIETOR—if you’re not incorporated you’re liable for just about everything.
As a PARTNER—same as above.
As a LIMITED PARTNER—usually your original investment, possibly notes. Can be unlimited.
As a SHAREHOLDER—mainly margin calls or share purchase loans.
As a GUARANTOR—to banks, trade creditors, landlords, bonding companies etc.
As OFFICER or EMPLOYEE—for personal negligence, or for actions of those you supervise.
As a DIRECTOR—a long list including GST and payroll deductions, unpaid wages, etc.
As a PROFESSIONAL—for negligence, perceived or real.
In a RELATIONSHIP—alimony, palimony, child support.
As a TRUSTEE OR EXECUTOR—for negligence, perceived or real.
Trade Creditors – Trade creditors are usually unsecured, but you may be a proprietor or partner, or have signed personal guarantees, or have opened yourself to personal liability (i.e. Directors’ liability, mechanics’ liens).
Employees – For unpaid salaries, holiday pay, severance, un-funded pension obligations, wrongful dismissal, hazardous conditions, etc.
Canada Revenue Agency (CRA) – As a Director you are liable for unpaid employee deductions and GST—but not unpaid Corporate taxes. You may be liable for sub-contactors’ withholdings.
Environmental agencies – Directors and officers may be sued for environmental damage.
Other Government Departments – Workers’ Compensation, regulatory agencies.
Banks – Most over-secure their loans. Sometimes they jump in if they fear CRA or another creditor will get there first.
Consumer Groups and Individuals—the visitor who slips on your step – Product liability cases, Class suits.
Losers looking for someone to blame – They sue everybody in sight. Doctors and other professionals for negligence. Directors in consumer cases.
Landlords and Other Lessors – You signed a lease. You may have guaranteed it.
Your Family – Your ex-partner, married or not. Beneficiaries of any trusts or estates you manage.
Creditor Proofing Techniques
Creditor Proofing often conflicts with getting wealthier or reducing taxes. It is important to balance the three—protection, getting wealthier, and your taxes. These notes deal only with creditor proofing.
Given the above, here are short notes on some measures to consider:
Do it EARLY
Do it while you are still solvent.
Incorporate before you need a limited company for tax reasons.
Consider who should own what when you buy the assets—not later.
Get your documentation straight from the start.
Separate your assets into ‘BOXES’ for protection
‘BOX Type 1’ = limited companies, trusts, bank accounts.
‘BOX Type 2’ = ownership by other family members.
‘BOX Type 3’ = other jurisdictions, provinces, countries, offshore
Separate business and personal assets. Let your spouse have personal assets.
Keep high risk ventures away from other assets. Use blind companies.
Put ‘HURDLES’ between you and your creditors
Have trusts owning holding companies.
Have holding companies owning operating companies.
Move assets up to holding companies.
Separate operating assets from investment assets. Do not mix in same company.
STRIP wealth out of Operating Companies
Move retained earnings up from operating companies to parent companies.
Put valuable assets in parent company, rent them to operating company.
Do not have outside shareholders in holding companies. Limit them to operating companies.
Sell minority interests in the business—not the real estate.
SECURE loans made from Low Risk to High Risk Companies
Make yourself a secured creditor.
Restrict bank security. It should be reasonable, not all encompassing. Balance a lower loan against a reduced security package.
Use LONG TERM NOTES for related party debts
Between sister companies, loans from a subsidiary to a parent, or to shareholders.
Make a creditor wait out the payment term. Use longer terms and low (or from time to time) negotiated interest rates.
Become a SECURED CREDITOR on large shareholder loans
Not usually cost effective for small or short term loans.
Put in place a standard security package that is easily updated.
Accept that banks will always want you to postpone.
Be careful with company assets used as security for third party loans to you
Not usually cost effective for small or short term loans.
Give direct security only on loans from company for housing, car or stock purchases.
Have Directors’ approval, draw up promissory notes.
Beware tax consequences of loans to shareholders and employees.
Put Leases in separate CLEAN Companies
You separate risk. Landlords do not like it.
Some business chains have one clean company per lease.
Do not cross guarantee leases. Do not sign or guarantee personally.
Avoid Corporate COVENANTS (Cross Guarantees by your companies)
Try to have each company stand alone.
Be careful with amalgamations, liability flows through to amalgamated company.
Review all cross covenants regularly. Clean up as you go.
Buy Adequate INSURANCE in Your Company
Business interruption, liability.
Life, disability (often inadequate and hard to collect).
Directors (doubtful—costly and consider taxable benefit effects).
Understand your coverage on all policies.
Professional—often mandatory. Include note in contract with your clients limiting liability to insurance amount.
Do not over-insure, or under-insure.
Deal only with insurers you know and trust.
Think HARD before you dive into Partnerships, Joint Ventures, Syndicates
Should they be incorporated?
Do not take over management in limited partnerships— it exposes you to liability.
Insist on proper documentation.
Own undivided interests in real assets—not partnership interests.
Hold partnership interests through limited companies.
Avoid tax driven schemes. They usually carry a sting in the tail.
MONITOR your Pledges of Collateral
Banks are usually over-secured—give adequate, not excessive security.
If you hit trouble you will need all your free collateral.
Understand what you have pledged, and for what amount of debt.
Remember—your banker may be your friend in good times, your jailer in bad.
If you have to pledge everything, you may be over-borrowing.
Know how rules on margining receivables and inventories work.
DIRECTORSHIPS = RISK
Know where you are a director. Paperwork often does not get changed.
Resign if you are not on top of the job.
Know your liability. Is it worth it?
Be cautious with non-profit organizations. What’s your liability?
Some boards have insurance. Know tax effects if you collect.
ALTERNATIVE FINANCING may reduce your risk
Lease vs Buy. Leases do not tie up your collateral.
Consider venture capitalists or angels.
Look for Government funding—Many agencies, Grants, Research.
Do not sign PERSONAL GUARANTEES lightly
Try borrowing without guarantees. Do not give up too easily.
Try for several and limited guarantees.
Get back all old guarantees. Get the documents—not a verbal understanding.
Review all guarantees from time to time.
Do not let your spouse sign guarantees.
Avoid guaranteeing for other people. Guarantees are contingent debts.
GUARD your Life Insurance
Keep investment type insurance in low risk Holding Companies.
Remember the CSV is an asset open to creditors.
Have spouse own and be beneficiary on your personal life insurance policies.
Build a long term relationship with a skilled broker/planner.
48% of Canadian Marriages End in DIVORCE
Where’s the danger? Your spouse? Your creditors? Both?
If you’re in the 52%, keep your spouse ‘safe’—no guarantees, limit liability risk.
Have your spouse own selected family assets—house, cabin, boat etc.
Dower Rights may protect you.
Know the costs of marriage breakdown.
Do a Pre-Nup before marriage, or matrimonial agreement later if you can.
List and value assets at time of remarriage.
Avoid having FAMILY Members as DIRECTORS
Reduce the risk of directors’ liability to family.
Let them be shareholders and maybe officers—but not directors.
Encourage spouse not to sign guarantees. Most prefer not to sign anyway.
Give spouse and kids non-voting shares as reason for refusal to sign guarantees.
Get ADEQUATE Personal INSURANCE
Life and disability.
Integrate your insurance with your will.
Understand difference between term, whole life and universal life, and which suits you.
Understand that some insurance is bought as insurance, some as an investment.
Buy insurance to insure. Insurance is for disasters—not to make your spouse wealthy.
Buy investment policies when you have used up all available tax sheltered savings (RRSP’s), and still have spare cash.
Do not count on your group coverage when working out insurance needs.
Use EXPERIENCED Advisors for Creditor Proofing
Use a first class lawyer
Document the important things and keep them current—Wills, Shareholder agreements, including family members. Matrimonial Agreements. Trust documents. Management agreements between companies. Employment agreements. Notes between companies or shareholders and companies. Minutes, resolutions, etc.
Make sure your lawyer understands what your intentions are.
Make sure all the documents work together.
Get cost estimates as you go
Do not hand over your wallet to your accountant or lawyer. Know the cost.
Go simple, rather than complex—when you can.
Do it before you need it, and dump it when you no longer need it.
Keep your own file on guarantees, schemes, devices, discussions.
Know that increased complexity does affect your business decisions.
Run your business properly. Run your investments like a business
Know when your business and investments are in trouble. Know your escape routes.
Know when to get out or step aside.
Plan to get out.
Put mental stop loss orders on your investments and your business.
Review all Wills, RRSP’s, Trusts, Insurance Policies from Time to Time
Review regularly and update.
Make all documents work together.
Choose executors/trustees wisely.
Do not ignore this whole area because it’s distasteful.
Leave personal notes on your investments, wills, documents, etc for continuity.
Keep a reserve in mind—someone who can step in if you are incapacitated—at work and at home (business only of course).
Maintain a Balanced Investment Profile
How many eggs do you have in one basket?
If you are in a risky business, choose safe investments.
If you need to gamble on hot tips, set up a separate investment account. Do not let it get too big.
Keep a liquid reserve. Have a cash nest egg that is there for emergencies.
A delicate subject—divorce and separation
Second and third marriages are now common; many do not last. Unromantic though it may be, the time to limit the risk is before the marriage or co-habitation.
Consider pre-nuptial agreements and family trusts.
Know the financial risks inherent in any long term marriage type arrangement.
AND—when trouble hits, work out a plan, prioritize your creditors, follow the plan
Pay banks, Government, Secured creditors.
If cash is short—communicate early with creditors. Keep talking.
Pay small amounts.
Do not be bullied by creditors.
DO NOT PANIC—people want to help you as long as you have been honest and forthright.
One Last Item
We are sometimes asked whether creditor proofing is ethical. ‘IT DEPENDS ON HOW YOU DO IT.’ The law frowns on transferring assets out of harm’s way by the almost bankrupt. It also reverses preferential payments. We’re not suggesting anything like that.
But we do remember the carnage in Calgary in the 80’s; we’ve seen what happens because of forgotten guarantees. We’ve also seen financial survival because clients gave themselves room to negotiate when things went wrong. They usually do eventually.
Many entrepreneurs roll the dice with their family’s security every time they do a deal—without knowing they’re doing it. They could have made the same bet without risking everything.
Matthews Group LLP
Chartered Professional Accountants
804, 322-11th Avenue S.W.
Calgary AB T2R 0C5