PROTECTING YOUR BUSINESS AGAINST LITIGATION

The assets of a business are often exposed to litigation and because of this most businesses are owned by limited liability companies. This protects the members from judgments against the business flowing through to them. However, using a company does not protect the value of the business itself. So, can the value of a business be protected from the risk of litigation?

The answer to this question is “Yes”. The obvious first step is to make sure the company has comprehensive insurance against liability to 3rd parties. However, insurance is never the complete answer and because of this, strategies have been developed to protect and preserve the value of a business.

At the outset, it must be emphasised that these strategies need to be adopted well before any liability is incurred, and not after the event. Otherwise, any transfers of assets by the business are at risk of being declared void under fraudulent transfer law.

To start off, the component parts of a business can be separated into those inherently at risk from litigation, known as “hot” assets, and those at little or at no risk of litigation, known as “cold” assets.

A simple example is a doctors’ surgery. The doctors as well as the business itself, are exposed to malpractice litigation. The business is therefore a “hot” asset. It is difficult (and expensive) to acquire and maintain all risks insurance for a medical practice. However, the business is carried out from premises which are unlikely to attract any risk of litigation. There will also be equipment, such as x ray and MRI machines, which do not of themselves carry any risk of litigation. These are the “cold” assets.

The next step therefore, is to isolate the ownership of the hot assets, (the business itself and any other assets which might attract litigation), from the cold assets (the premises and equipment). The hot assets are held by a limited liability company (the A company). If there are several hot assets then each might be held by different A companies to isolate any potential litigation risks from each other. On the other hand, the cold assets are held by the B company or companies. To address the potential personal exposure of the doctors, the membership interests in both A and B companies are held by one or more trusts set up for the benefit of the doctor’s families. Ideally any other personal assets of the doctors will also be held by trusts.

The B companies then charge the A companies rent for the business premises and for any other cold assets. Any surplus income earned by the A companies is regularly distributed by way of dividends to its membership holding trusts (as opposed to being paid out by way of salaries).

If an event of malpractice occurs, any judgment for damages will be issued against the business, as well as the relevant doctors in their personal capacity. If the doctors have not taken steps to protect the business (and their personal assets) from litigation, then all the assets of the business as well as their personal assets are going to be exposed to that judgment.

However, if the hot and cold assets have been separated and are held by separate entities, then it is much more difficult to enforce the judgment against the B companies which hold the cold assets. Likewise, the membership interests of either the A or the B companies held by trusts are not exposed to personal judgments.

The overall strategy then is to transfer the value of the A companies to the B companies, and through them to the B trust/s which hold their membership interests. It is noted that sufficient capital must be maintained in the A companies for their everyday operations, failing which a creditor may argue to pierce the corporate veil and attack the members.

This inevitably results in shrinking the balance sheet of the core business at the expense of the related companies and trusts. This of itself makes the core business of the A companies less attractive to litigation.

Structuring a business in this manner can have a negative effect on the growth of the business because the business will no longer have capital reserves with which to expand. In response to this, the B trust/s can provide secured lending to the A companies, and in effect become the treasury for the business, without exposing the corpus of the B trust/s to litigation risk. Likewise, the B trust/s are able to make new investments in new cold assets as well as make either advances, or distributions, to the doctors’ personal trusts as and when required.

There are other factors which need to be taken into account when considering applying this asset protection strategy to a business. These include:

• Availability of finance for expansion of business – banks and financial institutions often prefer to see one balance sheet instead of complicated group accounts for a business.
• Additional administration requirements – because the business is split up between a number of related entities rather than under 1 company. This will include keeping of separate accounting records and may require separate tax filings for each of the entities.
• Separation of assets – it may be problematic for a business to transfer assets it already owns, to a separate, albeit closely related, entity. Typically, these strategies are easier to apply to closely held businesses. Otherwise, a restructuring via a demerger is required. This will involve approval by other members and third parties.
• Taxation on separation of assets – tax issues may arise on the transfer of assets between related entities.

Other Business Examples

Contracting Business

A contracting business is high risk and therefore treated as a hot asset. The business also owns bare land, premises, and passive machinery (cold assets), as well as machinery and earth moving equipment (hot assets).

The business transfers ownership of the land and premises, as well as any cold assets, to a B company which is owned by a B trust. The business together with any hot assets are held by one or more A companies. The cold assets are rented/leased by the B company to the A company. In the event of a judgment being given against the business, the assets owned by the B company, as well as the value of its membership interests, are protected.

Fund Management Business

A fund management business is high risk, attracting litigation against both the business and its principals. It is a hot asset and is held by an A company. The business also owns valuable IP, trademarks, and patented software, all cold assets, which can be held by a B company. The membership interests in both companies are held by trusts. The B company licences its IP, trademarks, and software, to the A company. In the event of a judgment being given against the business, the assets held by the B company and the value of its membership interests, are protected.

Medical Supplements Business

This type of business can generate substantial profits but may be exposed to substantial liabilities in the future as ingredients come under scrutiny. It is therefore a hot asset. But it will also own valuable IP, trademarks, patents, as well as hold profitable contracts with 3rd parties producing long term revenues. These are all cold assets, which can be held by a B company. The membership interests in both companies are held by trusts. The B company licences its IP, trademarks, patents, and transfer its contracts, to the A company. In the event of a judgment being given against the business, the assets held by the B company and the value of its membership interests, are protected. While, the B company is able to provide finance to the A company to enable it to continue its growth, any investment in R&D will be made by the B company.

Offshore

The core business in most cases is going to be carried out in a domestic jurisdiction. That means the A company, at least, will normally be in that jurisdiction. However, there are distinct advantages to establishing the B company, as well as the trusts owing the membership interests in both companies, in an offshore jurisdiction. In particular, it becomes more complicated to issue proceedings against, and recover judgments from, foreign entities. The Cook Islands is one jurisdiction where both companies and trusts are given special protection against litigation.

Summary

The above strategies should never be seen as 100% watertight. Their success initially depends on the reluctance of litigation attorneys to act when there is no obvious deep pocket to sue. This creates an opportunity for a favourable settlement. Beyond that, other factors come into play, including the length of time the structures have been in place, the attention given to administration, and of course whether the facts are particularly egregious.

Contact for Further Information:

T&F Chambers Main Road
Rarotonga COOK ISLANDS
Telephone: +682 29-214
Email: info@trusteescookislands.com