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.
The core documents of an equity stripping system 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 filing.
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 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. If the borrower is 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 identity of the lender may vary. Ideally, however, the lender should have all the appearances of a disinterested, unaffiliated third party. An anonymity company that is not traceable back to the “borrower” would be preferred. Nevada is a good choice of venue for the formation of this entity, since the Nevada component may make it marginally more difficult for a plaintiff to obtain information or subject the lender to compulsory document production in a Texas court.
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: 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 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 would then pause and carefully 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. Similarly, a plaintiffs’ attorney who has accepted the case on a contingency basis may be wary. 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.
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 a stand-alone holding company. Activities are thereby separated from assets, greatly minimizing risk. Since in this system the management company is already a shell (or nearly so), it is the holding company that should be considered as a candidate for equity stripping.
Is equity stripping a form of fraud against creditors?
The answer is no, so long as the process is handled correctly. 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. No representation is being made to anyone on that score. The deed of trust and security agreement (the only recorded document) merely states the maximum possible loan amount and reveals nothing about advancements or other details of the loan agreement.
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; however, it is a corollary to this rule that one should provide only the minimum information necessary to be adequately responsive. If the plaintiff does not ask, then the defendant is under no obligation to provide gratuitous information.
The Issue of Existing Lienholders
Unless one’s company is fortunate enough to own its properties outright, then 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.
A County-by-County Process
Equity stripping can be a useful asset protection technique if a one has a substantial investment in a single property and legal action involving that property is a possibility. It is paradoxical that it may be in your best interest to appear less wealthy than you are, but by reducing the apparent worth of a company in the public records, a lawsuit may be deterred. Procedural note: equity stripping occurs county-by-county and Texas has 254 counties, so an equity stripping deed of trust and security agreement is usually filed only in the county or counties where the property is located. 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 documentation.
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 and statutes or cases referred to should be checked for updates. 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. This firm does not represent you unless and until it is expressly retained in writing to do so.
Copyright © 2019 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.