The 3 Pillars Podcast: How Do you Protect the Downside? – Building a Family Bank
In the fourth installment of the 3 Pillars Podcast, Peter Harper, the Managing Director and CEO of Asena Advisors and special guest Mike Abel discuss how building a family bank to protect your capital can perpetuate a successful family office especially in the case of liabilities.
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Peter Harper: So, folks, once again, welcome to the Three Pillars Podcast. Today I want to cover the folks that have a material excess and wish to do things to help their family. This can be as little as paying for education or as meaningful as funding business endeavors or the purpose of the home. How then should first gen families approach asset protection when it comes to distributing capital among their family?
Peter Harper: I’m always focused on downside protection. What do we need to do in this scenario to ensure my client has the same or more capital than they had yesterday? How do we protect, protect against marital misadventure or children? Today, I want to talk about the idea of a family bank and how capital should be deployed around a family group to ensure that the loans that are left to the family are protected from outside creditors. I’m joined today by Mike Abel, who is my partner in us, sit up, and he regularly advises foreign families on US structure and protection issues. Welcome, Mike.
Mike Abel: Thank you, Peter. I’m glad to be here.
Peter Harper: So, Mike, can you please tell the listeners what asset protection is why it’s so important in the US?
Mike Abel: Yeah, especially in the US, as you know, we are one of the most litigious countries out there. And I always tell people that they jumped the gun a lot of time ago to estate planning for asset protection, because to be blunt, if you don’t protect your assets, you’re never going to have an estate to worry about. So when we look to protect assets in America, we do a lot of different things. You have to look at the types of assets that they have now. And I was talking earlier about how is the asset that you’re looking to protect an active asset or is it a passive asset? And what the difference is between those so you can get to know how to identify them. An active asset, I always think of is nothing to do with taxation, but that it creates risk. It can create a judgment. Think about your rental unit. I always tell everybody, if you have a rental unit or you have different rental units, you’re crazy if you own them in your own name. Then you look at other ones – Cars for example. These types of assets create liability in themselves. So with those, we need to make sure they’re all in an LLC, etc. Then we have passive assets and that’s something we’re going to use a lot with family banks. A passive asset – think of it as cash – cash equivalent, stock, mutual funds. You know, we’ve never had a mutual fund in a car accident, as far as I know. So it can’t create a liability. And we need to make sure that all of these assets are segregated. You’ll never mix an active asset with a passive asset. And we make sure that each active assets basically in a separate LLC. So these are some of the things that we do in the US when we’re looking at protecting assets. And we can go ahead and get into more with putting in holding companies and stuff like that. And if you want, I can go on to explain a little bit of why we use an LLC over a corporation.
Peter Harper: Well, I mean, I think the thing that’s kind of important baseline to understand is – I like that you talked about segregated assets and active vs. passive. That’s one thing I think that folks need to understand is generally practically what happens if there’s some form of liability. So something happens with a tort or something contractually. Right. with respect to an active asset where there is real risk. So someone sues you, they get a default judgment or they get there successfully getting a judgment against – whether it’s you personally or the entity that that liability sits with and then they are able to look to enforce that judgment against you personally or the entity that relates to. The reason why I’m asking about segregation is because if someone is actually successful with a client, right. Then they can only enforce that against the assets that are owned by that same entity.
Peter Harper: So in the perfect world, you would have every single asset you own sitting in its own entity. Right, so that the risk is only limited to the asset that you own. But depending on the value of entities, it can get quite expensive for people. So a bare minimum, right, as you’ve talked about, you should be segregating assets and saying, OK, active assets where there’s a lot of risk sitting in one bucket, definitely not in my own name. Passive assets sitting in another bucket, again, definitely not in my own name.
Mike Abel: Exactly. And that’s what we always structure when we’re looking at asset protection to make sure. You never mix an active asset with any type of passive asset because you’re put them all at risk if you do and you have a risk of losing everything.
Peter Harper: Now, that’s great, I mean, I think this leads into this great topic. For a lot of entrepreneurs that are going through this process of selling a business and realizing a significant amount of capital, I know from firsthand experience that they are thinking of ways in which they can sprinkle or deploy capital around the family. It’s largely for personal use reasons, but maybe to fund them into other businesses or ventures and we’ve had a bit of experience with forming and managing family banks for high net worth and ultra high net worth families. Mike, can you please give the listeners a bit of an overview of this concept? What does it mean by a family bank? Is it licensed? Is it lending to people outside the family or within the family only?
Mike Abel: Yeah, sure, no problem when we set up family banks for individuals or couples or whatever for their family use, we go ahead and use the LLC or could be owned by their trust or irrevocable trust in anyways. We have the family bank set up. It’s a non licensed entity and we don’t use force. We put capital in it and then within it’s business purpose. It states that it is to be used only to make loans to family members – blood family members. You can spell out how you want to define that. And then by doing so, the owner of the bank, you, can go ahead and assist their children or grandchildren, brothers, sisters, whoever it might be in the family in bettering their own life, so that we don’t need to go to a bank and they have to worry about all the banking processes, etc. The family bank can go ahead and decide that, yes, I want to give my granddaughter two hundred fifty thousand to help start her business.
Mike Abel: And the beautiful thing is by using your own family bank, we can preserve capital. And what I mean by that is when we operated the family back, we make loans to our family members. Those loans are secured just as if we were a bank. If they borrowed real estate, we secured against a real estate mortgage deed of trust. If it’s any type of chattel we use UCC filed, we create liens just as if we’re a bank. And by doing so, we are protecting the money that we give them from their creditors. So if something would occur in their life, that would go ahead and cause in the event of duress for them that they were going to lose money, we as a friendly creditor, can come in and take over the assets. We can foreclose, we can preserve our capital that can then be redeployed to anyone else in the family, them or another family member. So it’s a real nice concept. If family members want to help other family members succeed in life, give them a leg up. Use your wisdom and experience along with some of your money to give them a shot to hopefully and eventually start their own family bank or even become a partner in yours.
Peter Harper: You know, I love it as a concept. I mean, I think that know, particularly in the area where various family members stop to get married. I mean, the thing is, when you starting to talk about children and inherited money versus folks that may not have come from the same same background and you want to ensure that not only your own capital is protected, but that of your your is putting them in a position where you know that they can they can have you know, they can have assets such as a first home and or second home you provided by the family without putting that at risk if they were to get married. I think it is a is a major asset.
Peter Harper: And Mike, you know, when we were touching on this before, one of the things is, you know, we were talking about the ability to charge interest vs. not charge interest. I wanna do two things I want to tie this back to the conversation we’ve just been having when we talk about structural options and the benefits of charging interest. But I also want to talk about why debt, when it comes to asset protection, why debt is superior.
Mike Abel: Yeah, debts are superior to equity, because you’re first in line to get paid, if I loan you to purchase real estate and you’re going to buy an LLC and build an apartment complex. If I say give me equity and I’m sitting there with equity and all of a sudden somebody gets hurt in the apartment complex or they find lead poisoning or whatever it might be and the apartment complex gets sued, my investment is at risk. Everything that I put into it is gone if they get a judgment. However, if I use debt, then my liens get paid back prior to any other claimant. That’s because my money would be the purchase money mortgage or else it would be invested prior to the event that caused the liability occurred. So by sheer priority, I get paid back. And if you work it out like I do with one gentleman that loans a lot of money, just family members, we have all sorts of default interest rates and everything worked in with the obligatory instruments. So that is any event of duress occurs within his kids, his interest rate goes up from four percent to twenty four percent as a way to try to claw back more money within to the family bank. So it’s an ingenious play.
Peter Harper: Yeah. And in those top provisions, I think when people are listening, hearing this for the first time, go, How did the mechanics of that work? I mean, that’s no different from from when you think about a default rate with the bank. I mean, if your credit rating is going from good to bad. Right. Or you’re late paying, it’s no different to how a credit card company might treat you or how a bank might treat you. Right. If you’ve got some form of variable rate or or, you know, any of these forms of default just trigger the provision which has to be repaid immediately. So, you know, I think I think when folks get their head around the concept and how valuable this can be to a broader family, the way I like to think about it, it’s like you’re putting this sort of shield, this shielded umbrella out over all of your family and they’re out there operating in the world.
Peter Harper: You may not be seeing what they’re doing, but you’ve put in place this mechanism that to the extent they get themselves in any form of trouble, whether it’s through, as I said before, to some form of tort or to some form of negligence and claim resulting in an economic claim or its contract, some form of contract dispute resulting in an economic climate, there’s an ability for the capital to be protected. And one of the things that we always like to focus on within our business, we talk about downside protection all the time, all the time. How do we ensure our clients have more tomorrow than they had today? And I think as substantial capital, who is not focused on the dispersement and management of their capital within their family unit in this way, is missing a massive opportunity.
Peter Harper: And I think that the another point that I’d sort of just put on this is that I think often is overlooked, a lot of people out there with go, oh, why would I worry about any of this stuff? I’ve got insurance.
Peter Harper: Insurance policy are written to not be paid. Right. I mean, if I thought of the insurer, I’m trying to do whatever I can to scale down. The ability for someone to actually call on the payment of the policy in, you know, if clients actually spent the time and energy to actually look through their policies, I mean, it might give them some form of comfort. Right. But the majority of policies out there aren’t worth the paper they’re written on.
Mike Abel: Well, I’ll give you a I’ll give you a prime example of one of my clients when I was in Ohio. They owned an up down duplex, you know, you walk up the first floor, one room, you walk up steps onto a landing, second duplex or unit is up there. Well, he had it rented – luckily we have it into an LLC, its own LLC and everything – but they had a Christmas party at the up unit. And during the Christmas party, a bunch of them went outside to smoke and one of the guys leaned against the railing. They left, the railing broke, and he’s a paraplegic. They, of course, sued my guy who had an LLC. We thought he had insurance, too, except for they went to the tenant and started asking him about the accident. And the tenant informed the insurance company that “I told that landlord months ago about that loose railing and he never fixed it”. The mere fact that the landlord did not fix it negated all his insurance coverage. They refused to pay because under the policy, if you have a known defect that you do not fix within a reasonable time, that defect becomes an exclusion. If we didn’t have his property into an LLC and it was in his personal name, he would lost everything. So insurance companies number one job is to not pay claims. So I used to work at one. I know the title insurance. That was the first thing we did is not pay claims.
Peter Harper: Sure, sure. I mean, that’s the one big thing. You know, it’s funny. Like whenever anyone comes to me, you know, we talk about asset protection and it seems like we were either overengineering the entities, you know how much because it’s going to cost and what’s the ongoing compliance. And I say OK, work out that number, let’s look at your insurance costs and then let’s compare – let’s actually look at the risk we’re quantifying. And we know, right, provided you’re complying with your performance, you’ve actually got a proper insurance policy around that to compare the two. And, you know, I can tell you every day of the week that that is going to result in a better outcome than than the money that he’s spending on insurance. I’m not saying, folks, don’t get insurance. I mean, you should have everyone should have insurance. But believing that insurance is going to solve your problems solely is is crazy.
Mike Abel: Right. And I tell people to, as I say, always get your insurance, get your umbrella policy. However, don’t count on them. Let’s set it up that if something happens, you’re going to be safe.
Mike Abel: One thing I to bring about your family bank to that is important with any asset protection, because I was just thinking about it because of being like you one time in California and stuff, you have to look to the state where you want to form the family bank and hopefully have some roots there.
Mike Abel: And the reason why I say that is every state in America has different laws concerning with piercing of corporate veils and stuff like that. And I always advise people, especially if they’re out of the country and they don’t really live here. We pick a state such as Ohio, Arizona, Wyoming, Florida that has great L.L.C. laws that you can’t pierce them or anything rather than putting something in California that can be pierced. And where that would come into play is say, I started my family bank and I have ten million dollars that I’m loaning to my kids and I go out and get to a horrific car accident. If I live in California, they sue me, they get a judgment they can actually go into and pierce my assets and take my money out of my LLC. If I lived in Ohio or Arizona, they could not do that. So it’s all depends on where you live and where your LLCs are at
Peter Harper: But what about if I live in California and they set up in Ohio?
Mike Abel: We have to look at where the incident occurred and if it still occurred in California, then a lot of times California courts will determine that we don’t care about Ohio law. We’re going to use our law. However, if we did proper layering with different policies and maybe I have the family bank its own out of out of Arizona, it’s own to Ohio and it’s back to California, that extra layers and that being protected. What it does is it makes a settlement very, very more attractive to creditors.
Mike Abel: What if a creditor comes after you or your attorney? What we are looking at is what can we put in our pocket? And we look at the expenditure of time and effort it’s going to take to put it in our pocket. And when we see somebody that going to take millions of dollars just to try to get that service in the state or to bring them under our corporate umbrella, then to pierce viels, everything. Suddenly a judgment of five hundred thousand dollars becomes worth one hundred and twenty five thousand dollars because we’re not going to spend the time to go after it. And that’s why I would tell a lot of people that that’s what a proper asset protection plan does is. It puts a big deterrent out there to say, do you really want to go after my asset? And so many times people don’t. We used to make a joke of it back when I did do litigation in Ohio that when somebody came in and talked to us, the first thing we did is search for assets to the person we’re going to sue. And then if we find that it’s a complicated plan or everything, we refer them to an attorney that we do not like. So they waste their time. So it’s just that’s one of the reasons why we do all this.
Peter Harper: But the great thing about this discussion is that it also highlights the value of using, you know, using non US locations as capital. Well, provided they’re sort of tax neutral. Right. I mean, this level of protection, if you want to talk about someone getting a judgment and enforcing it, ratchets up to an even higher level. If you’re storing cash or assets in foreign jurisdictions that have a lot of protection rules as well.
Peter Harper: Yeah. So some Mike, They say nothing’s more certain than death and taxes to the law. Well, I should say death, taxes and divorce and so the last topic I wanted to talk about is how that folks should be thinking about this concept of the family bank when it comes to a family member who’s going through a divorce. You know what happens to the asset and what’s the value of having this type of security in place of somebody that’s happened.
Mike Abel: Yeah, let’s assume that they didn’t do any preplanning when it started, so it’s either considered under the state law, community property or joint property. Well, the spouse is going to be awarded part of that or else they’ll get awarded a comparable amount in some other asset. However, if we have that loan on there, then at least the money that you gave your child or your family member is not going to go to their soon to be ex-spouse. So we can go ahead and preserve that and make sure that it stays separate property.
Mike Abel: I do know on some of these loans that we’ve made, our lender has required the spouse, no matter how long they’ve been married, to sign off on the property, especially on community property jurisdictions, to make its own separate property of their direct family members. That way, if something did occur like that, it stays that family member’s property. So all depends on the structure you do up front that you do have to guard against that, because like I say with my wife, I tell her all the time something happens between us and she can have everything. I don’t care, but she better never, if she gets remarried, give that person a dime because I didn’t work this hard for that. So you can do some of that with a family bank and it makes it good.
Peter Harper: I mean, that’s the thing that I think about. I mean, there’s a lot of information out there about prenups. You know, they’re more common in America than they are in a lot of other jurisdictions that they’re gaining – yeah, they were gaining popularity in outside, you know, in certain other countries. But there’s hotter issues as far as, you know, enforcement.
Peter Harper: But I think that when you talk about intergenerational wealth, when you’re talking about a situation where you’ve established your bank, you put capital in it, you’ve lent that to family members, to children, if that is managed correctly, to me, that’s far more powerful than a prenup, right. Because it’s clearly established that it’s a family asset. And there’s big security over the asset. Right. So if something happens, I mean, prenups have their place. And it’s obviously when if you got children that are inheriting, you know, substantial wealth, they should still be going through and putting that in place. But I think the combination of the two is a really powerful tool.
Mike Abel: There’s an additional thing that you can do that we use in some transactions dealing with to protect against this when we use debt instruments or even if, say, like you said earlier, about getting equity in the property, you know, the difference in debt and equity, we will do our obligation document will be a note with what’s called an equity kicker. What that says is that, hey, this is the note. You owe me everything back on a note, but a due on sale clause, anything triggers in there that requires you to pay it back. You also owe me as an additional to what we gave you, a percentage of the growth of the company that you have. So we get part of the equity back. So you can even use that to say that one spouse is not really too happy with signing off anything, then just put an equity kicker in there to at least the family bank can save your family, your child or grandchild, an additional 25 to 50 percent interest in the equity in the property. So you retain wealth that way. Sounds like a dirty trick on the other side, but I drafted it for families.
Peter Harper: Now, listen, I think the thing is that what we’re talking about is capital that’s being created by our generation and it’s looking to be provided to the next generation for their benefit. And the family members benefit while those people are in the family if they’re if they play the gigs up and that’s the rule or the purpose of the bank. I mean, how much experience do you have with prenups and what I mean, how important are they?
Mike Abel: They’re very important. We’re a little bit hybrid here in Arizona where a resident now we do pre and postnups. And as long as you go ahead and you’re there up front, you provide them with a detailed list of your assets and everybody goes in wide open, eyes wide open. They generally hold up. Other jurisdictions, they’re not as you know, the courts don’t like them as much. They’ll give reasons for allowing one spouse out of it or not if they deem it to be too harsh or the time frames everything. So it’s very state-specific. In Arizona, I can say they work a lot better than they do for the state compared to California, for example.
Peter Harper: Let’s say you do the prenup in a state like Arizona where it’s more preferable than in California. Right. So you married in Arizona, but then you go to California. Is California still going to overlay California’s rules over everything that they’re going to say? Well, no, this was done in Arizona. Therefore, you can rely on Arizona law.
Mike Abel: Well, I wish I could say one hundred percent, because they should as a choice of law, because we put choice of law provisions within the agreement, we apply Arizona law. But I’ve seen California courts go do whatever they want. You know, we are you know, I always joke that, you know, we in Arizona are the independent country of Arizona. California is the same way. They’re the independent country of California.
Peter Harper: I think California is on the fringe of everything. They do what they want and when it comes to law and the reason why I think when it comes to asset protection, specifically we talked earlier about US being a litigious country, California is probably the origin of most of the scary stories that foreign families have heard about, right, because it’s it has a tendency to not necessarily always accept the terms of the contract and overrule it on the basic principles of equity or other forms of statute. Right.
Peter Harper: Whenever I’m talking to folks about asset protection, you know, I always start the dollar where I’m looking at this and say, you know, because this is the big thing with asset protection is that: You have to be willing to go through a process and let the client run its course, right? So someone goes in to get they get a judgment, right. Look to enforce it. And then there’s a question of the location where the assets, can we enforce it. Right. And as you talked about, it’s part strategic, part practical, part law. Right. It’s the combination of these three things. And at the end of the day, you’ve got to look at what is what I think what is it about an asset protection strategy that’s driving it? I mean, what is your objective for me? And this is the way we always like to talk to our clients. It’s about capital protection for your family, insuring your more capital tomorrow than you had today. And if you’re that focused, then asset protection is going to be all part of any wealth planning strategy. Right. And it’s like, okay, well, what are the different layers of protection that, you know, that that you’ve got? And it’s either going to be regional. So you’re looking at regional options or opportunities within the US or you’re saying, OK, we want to make this a belt and braces approach, that we’re going to stick this up and move this to another country
Mike Abel: That’s all dependent on your wealth, what your wealth is.
Peter Harper: Correct. It’s got to be material. I mean, this stuff and these structures and information and stuff can get expensive. So you’ve got to be able to justify, right But it’s as I said at the start of this, is like, you know, what would it cost to insure your risk Assuming you could go and get insurance to cover the risk that you have. Right. What would that cost? So if you can do that, back to the napkin math and say ok, the cost of this structuring is less expensive. More of the same costs is what an insurance would cost if I could cover it, then I think you’re ahead of the game.
Mike Abel: Absolutely. Way ahead of the game, and I always tell them also what would be the cost of a loss. So what are you comfortable losing? Because One, you lose one of your properties you can live with, you lose 10. You can’t.
Peter Harper: Yeah.
Mike Abel: So you have to look at compared to your asset, what percentage of them are you willing to give up to ensure that you’re going to keep the remainder? If I could go ahead and say I’ll give you five percent of my net worth today, Peter, to guarantee that I’m going to have 95 percent of it and all the growth it does over the next 20 years. I’d write you a check.
Peter Harper: You know, it’s it’s fantastic. Well, Mike, it’s been a great, great session, I really enjoyed it.
Peter Harper: I think it’s an area that a lot of folks can overlook until it’s too late. Right. Because they like all that stuff is never going to happen to me. But I know the big thing I would leave with everyone is I would go I would look at all your assets and quantify your risk, the risk that exists in your life today. Right And then say, okay, this these are three questions.
Peter Harper: What assets to I own? And then what risk is associated with that assets?
Peter Harper: Can I get insurance? Do I have insurance?
Peter Harper: And then thirdly, is the insurance sufficient, legally sufficient, the way it’s been drafted. Right. To cover any perceived risk.
Peter Harper: And if you can’t get to a comfortable answer when you’re really trying to address those three questions or areas, then you really need to spend the time and money to focus on a proper strategy.
Peter Harper: OK, Mike, thanks again for dailing in and I look forward to catch up with you next time.
Mike Abel: All right, thanks, Peter. Talk to you later.