Equity Stripping for Asset Protection

by David J. Willis J.D., LL.M.

Introduction

Equity stripping is the art and science of making a business appear to be worth less than it really is. It has been said that perception is everything, an aphorism that is definitely true in asset protection. If a review of public records indicates that a potential target company is in debt and its assets are encumbered by liens, why would a plaintiff file and pursue an expensive lawsuit in order to wind up with an uncollectable judgment? A target company that is apparently judgment-proof may make it less likely that a contingency-fee attorney will accept a case against it.

Core Documents

The core documents of an equity stripping program are:

(1) a secured promissory note in a substantial amount (usually authorizing funding of up to $1 million or more);

(2) a line-of-credit agreement supplementing the terms and conditions of the note;

(3) a deed of trust and security agreement listing real and personal property collateral subject to a lien to secure payment of the note;

(4) a company resolution authorizing the loan; and

(5) a pre-signed release of note and lien held for later recording.

Only the deed of trust and security agreement is filed of record, but that is enough. This document states clearly that both a company’s real estate, the improvements, and its FF&E (furniture, fixtures, and equipment) are subject to a first lien to secure repayment of a very sizeable amount of money. The other equity-stripping documents are kept with the company record book as documentary support.

The note is payable on demand. The borrower should be the investor’s limited liability company. In a two-company structure, the borrower should be the holding LLC. If a series LLC, the note should state that all series are jointly and severally liable for payment, not just the company at large.

What about the lender in an equity-stripping scenario?

The lender is a specially-created anonymous entity that should have all the appearances of a disinterested, unaffiliated third party. An anonymity company that is not easily traceable back to the borrower is preferred. (Anonymity may make it more difficult for a plaintiff to obtain information or subject the lender to compulsory document production in a Texas court.)

Texas and Nevada are good choices as states of formation, but because of increasing disclosure requirements Wyoming is probably the best formation state since virtually no information about LLC managers and officers is available online.

How is the lien released?

The easiest method is to hold a pre-signed and notarized release in reserve until it is necessary or advantageous to file it and undo the equity stripping. Alternatively, the equity-stripping lender can conduct a friendly foreclosure with the goal of eliminating any subordinate liens that may have arisen against the property.

The Role of Deterrence

Recall that a key principle of asset protection is deterrence. Deterrence in the form of equity stripping affects the process at two possible points: (1) first, when the plaintiff and his lawyer perform due diligence (as they likely will) on the available assets of their target before launching a lawsuit; and (2) second, during document production, when the defendant produces copies of the note and the deed of trust and security agreement—documents which, at least on paper, vastly reduce net worth.

Given the soaring expense of litigation, most plaintiffs (and their counsel) would then pause and evaluate the prospects for a tangible recovery. After all, a lawsuit is just another form of investment and a rational plaintiff is looking for a return on that investment. After a review, the attorney may even go to the client and demand a substantial retainer if the case is to proceed. Result? The lawsuit may end there.

Similarly, a plaintiffs’ attorney who has accepted the case on a contingency basis may be wary of continuing to invest his own funds in an apparently lost cause.

Equity Stripping and the Two-Company Structure

We recommend a two-company structure for most real estate investors: one LLC as a management company and another (often a series LLC) as a holding company. Activities are thereby separated from assets, greatly minimizing asset protection risk. Since in this system the management company is maintained as a (near) shell, it is the holding company that should be considered as a candidate for equity stripping.

Is equity stripping a form of fraud against creditors?

No, so long as the process is handled correctly. Fraud is misrepresentation. Equity stripping documents do not do that.

The note is a line-of-credit note which authorizes advances of up to $1,000,000; but the public filing does not indicate how much money (if any) has actually been advanced. It could be the full amount; it could be zero. Remember, this is a line-of-credit note. It is unrecorded. No representation is being made to anyone.

The deed of trust and security agreement (the only recorded document) states the maximum possible loan amount but reveals nothing about advancements. Basically, all the equity-stripping deed of trust says is this: if any funds are advanced under the line-of-credit note then repayment will be secured by a lien on the security property. No representation as to the amount of advancements (actual or intended) is made.

It would be a different matter if one is queried during the discovery process as to how much of the loan had been advanced. One should never be untruthful in discovery. In any case, by the time one is in discovery (either pre- or post-judgment) then the deterrence intended by an equity-stripping program is long in the past. Deterrence is over. The lawsuit has happened. Equity-stripping is not a lawful post-suit technique for asset protection.

The Issue of Existing Lienholders

Unless one’s company is fortunate enough to own its properties outright, there will be existing lienholders to consider when it comes to equity stripping. First-lien deeds of trust recite that the priority status of their lien must be preserved or the borrower will be in default. Is this a problem? It should not be. The reason is that the deed of trust and security agreement used for equity stripping expressly states that its lien is inferior to earlier liens of record. It does not try to compete with these prior loans at all.

A County-by-County Process

Since real property in Texas is indexed county-by-county, equity stripping must occur county-by-county as well. An equity-stripping deed of trust and security agreement should be filed only in the county or counties where the property is located. Texas has 254 counties so multiple recordings may be required.

The usual procedure is to strip the equity of each individual property separately. However, when there are a large number of properties, an alternative approach is to group the properties by county and file a blanket deed of trust against all in-county properties at once, avoiding the need for excessive recordings.

Equity stripping can be a useful asset protection technique if one has substantial real estate equity and legal action against that equity is a possibility. It is paradoxical that it may be in one’s best interest to appear less wealthy than one is, but by reducing the apparent worth of a company in the public records a lawsuit may be deterred.

DISCLAIMER

Information in this article is provided for general informational and educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes. No attorney-client relationship is created by the offering of this article. This firm does not represent you unless and until it is expressly retained in writing to do so. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well.

Copyright © 2024 by David J. Willis. All rights reserved. Mr. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his website, www.LoneStarLandLaw.com.