Creditor Proofing

 

Introduction

 

As I have gotten older and perhaps wiser, I have realized how little has been written on this subject that, at least to my mind, is reputable and trustworthy. Bankruptcy trustees, who are supposed to give someone in trouble impartial advice, can’t help perhaps but be influenced by the fact that if you decide to go bankrupt, that’s a new customer for them. Banks and financial institutions are unlikely to be your friend in need if you are facing a financial question. They are as likely as not, upon hearing that you may be in financial trouble, to call your loan immediately—so they can be first in line to get your remaining financial assets before someone else does or before you can either fritter the ‘estate’ away or transfer it to someone else (e.g., a spouse or adult child.)

 

It won’t matter to them that if you did, in fact, transfer your assets away within a year or so of a bankruptcy, this could be considered fraudulent and reversed by a bankruptcy trustee appointed by a court to organize and supervise your affairs. They will place you in their ‘special loans’ division—those are scary people who only care about minimizing the Bank’s loss. When you’re in ‘special loans’, you’re in a heap of trouble.

 

There really is no such thing as ‘Creditor Proofing*’; it’s a misnomer. When people use the term they are primarily thinking of putting their money in secret overseas, numbered bank accounts, protected by bank non-disclosure laws in neutral countries like Switzerland or ‘pirate’ havens in the Caribbean. Well, I have bad news for you—the Swiss won’t do this anymore and there are fewer jurisdictions anywhere that want to because the cost of not being an accepted part of the international community—being an outcast nation—is so high.

 

(* Every year, the lecture that I give on ‘Creditor Proofing’ in my course at Carleton on Entrepreneurialist Culture seems to be the one lecture that my students ask the most questions about so I figured it was time that I wrote this up as an essay that other might find useful too.)

 

Neal Stephenson wrote a ripping good yarn about a group of California-based techies who work to create an overseas data haven in his novel, The Cryptonimocon. A ‘data haven’ is another phrase for a pirate bank really; what is money these days but data? If you use Internet banking today, all you are doing is paying your bills or moving your money about as binary code—1s and 0s. So a data haven in Stephenson’s imaginary Pacific Island nation would be just another place for people to hide some of their wealth in.

 

But frankly, if you have to resort to this, you are already in trouble and maybe doubly so. If you throw your lot in with thieves and mercenaries in pirate nations, you shouldn’t be too surprised when they find a way to rip you off. And to the people you deal with in whatever nation you live, you will have lost a lot of their trust and a lot of your credibility too so, no, I don’t think off shore secret accounts are the right way to do things.

 

My late father-in-law, Ken MacMillan, was an old fashioned guy. He thought that the best way to credit proof yourself was to not have any creditors. He listened to pitchmen selling mutual funds and laughed. He felt that the stock market was a mug’s game—only the insiders win. He kept his money in a savings account in the Bank. He paid all his bills on time. He lived within his means. He saved money every month. He paid cash for his home and only purchased what he could afford.

 

When Ken passed away, his estate attracted no death duties or terminal tax liability because he kept all of his money in cash so there was no deemed disposition of stocks, RRSPs, property (other than his primary residence, which is tax free in Canada anyway). The Canada Revenue Agency (CRA, the equivalent of the IRS in the US) didn’t take away half of his estate; and there were no lawyers and accountants involved to take away the other half. Distribution amongst the beneficiaries was done without issue or quarrel unlike many other more so-called, sophisticated families and their estates that I have known.

 

I don’t think my father-in-law thought much of me; I was a young smart aleck as far as he was concerned involved as I was in ‘Big Business’. I had had all the advantages in life—smart parents who emphasized education, private schooling and three degrees. Plus I was fortunate to be born in a country like Canada where people don’t try to shoot you and where there is great opportunity.

 

Yes, I had it all as far as he was concerned including a great wife (his daughter). But also I had built first a real estate empire and then a (NHL) hockey franchise together with a huge land assembly, largely with debt. He was not impressed.

 

The late Harold Shenkman, the Founder of Shenkman Corporation, a very large real estate holding company in Ottawa once told me that: “…the way I have kept a good relationship with my Bank (the Royal Bank of Canada) for over 40 years, Bruce, is that they have always owed me money.” It took a few seconds for it to register and then I laughed as Harold expected me to. Shenkman Corporation had always had more money on deposit with the Royal than the Royal had loaned to them.

 

When his son, Billy asked me what I was going to do in 1982 when, as a young fellow I first got into business, I told him I was going to build office buildings. Billy said he was going into parking lots. I laughed. At the time, parking in downtown Ottawa was going for about $25 a month; office rents in the western suburbs were around $18 per square foot triple net. By 1987, parking rates were up more than threefold to around $80 a month while office rents were down to about 6 bucks. Running a parking lot is incomparably easier than developing office complexes and a lot more profitable too, especially if you already own the land. I don’t have to tell you who has had the better financial life—Billy or me. I’ll leave that to your imagination. But certainly, Ken MacMillan would have understood what Billy was proposing to do—keep things simple, don’t over extend, buy what you can afford to pay for, in cash.

 

I was thinking of my father-in-law, one day in 2000 when I went to my Bank to see how my mutual funds were doing. I had left $100,000 in cash with the Private Bank (an arm of the Bank for upscale customers only) in 1995 for them to invest in their Bank mutual funds for me. Before that I had these particular funds in GICs (Guaranteed Investment Certificates) and some term deposits. These are not very exciting investments—but the principal amounts are guaranteed by the Sovereign (i.e., Canada) up to a certain preset amount as are Bank savings accounts also up to a preset amount so they aren’t very risky.

 

I talked with my private Banker and somehow I seemed to recall that one of the pitches they had made to me initially was that I would receive a monthly statement ‘every month’ (!) no less, so I would know precisely where I was at. But I don’t recall ever seeing one statement in the five years they had control of these funds. When I asked to see how my portfolio was doing, I got a series of excuses—it will take time to pull a statement together (that bought them three weeks). I was also told: “You have to remember that you can’t judge the performance of the Bank’s mutual funds over a short period of time.” Finally I said: “Walter (not his real name), I’m not mad, I just want to see a statement.”

 

Well, in the greatest bull market in my lifetime and maybe ever (1995-2000), the Bank’s mutual funds were among the 10% worst-performing mutual funds in Canada and they had managed to lose a compounded average of 2.5% per annum during that period. They had turned my $100k into less than $90k; a monkey throwing darts at a list of Canadian mutual funds would almost certainly have done better. Ken was right, I would have been better off with my cash in my mattress.

 

How to Get in Trouble

 

How do people get in trouble; how do educated people with all the advantages get in trouble? I am sure that there are an enormous number of Canadians and Americans (and other nations’ citizens too) who are headed for or are already in dire financial straights. There is an incredible industry that has evolved to ‘help’ people out of trouble—many of these helpers are dubious in my view but more on that later.

 

First, what are the symptoms that you are in trouble? Yes, you need to self diagnose; like compulsive gamblers or alcoholics or drug addicts, before you can get better, you need to know and admit that you are in trouble.

 

Here are a few of the symptoms:

 

·       you do not pay off your credit card balances every month;

·       you receive multiple applications for other credit cards in the mail and you complete these and get those cards too;

·       you miss payments;

·       your bank lines are maxed out;

·       you bounce a few cheques by mistake;

·       you can’t keep track of all the payments you have to make;

·       creditors start calling your house;

·       your spouse goes out to buy an appliance on OAC (On Approved Credit) and she is rejected because your credit rating (measured by your Beacon score) has fallen below 650 or 600;

·       your bank calls your personal loans;

·       you can’t get another mortgage on your house;

·       your bank wants you to change your Line of Credit into a term loan so you pay it off and then they won’t renew it;

·       you need to go to private lenders for loans at much higher than prime lending rates.;

·       you can’t get any new financing at all.

 

You get the picture and it isn’t pretty.

 

Now what causes this? Well, we have hinted at a few reasons—you have a drinking problem or a problem with drugs or gambling. I came to realize how bad compulsive gambling can be when an acquaintance of mine (an Appraiser) told me (proudly) how he had recently tweaked his business model to make his firm much more profitable.

 

As someone who studies and does research in entrepreneurship with an emphasis on business models, I was keen to hear how he could transform what is essentially a pretty simple (and a bit boring) business. I mean appraisal firms basically send out a bunch of appraisers to assess the value of your property to make sure it meets the minimum FMV (Fair Market Value) that the Bank needs in order to get its money back from the QSV (Quick Sale Value) of your property.

 

So if a Bank has tentatively approved, say, a home mortgage for you with a LTV (Loan to Value) ratio of 75% of the FMV, the FMV is the appraised value and not what you say it is. Basically, if you stop making your payments and the Bank seizes your property through a Power of Sale notice, they want to be able to realize the QSV and it had better at least 75% of the FMV otherwise the appraiser is likely to get sued*. The Bank wants their money back for sure. (In commercial transactions, the LTV ratio can be a lot lower (often 50%) and the QSV (basically what the Lender can get for your property in 90 days or less) is sometimes used in place of the FMV so the lender is ‘doubly’ protected from loan loss.)

 

(* By the way, as people found out in the Alberta economic meltdown of the 1980s after the hated Liberals imposed their National Energy Program which crumpled their oil industry, you are not off the hook even if you hand your Bank back the keys to your house. (Thousands of people did this in Alberta when house prices sunk to such a degree that the principal owed on their mortgages greatly exceeded the FMV of their properties). After the Bank had finished selling these homes for distressed values (i.e., QSVs), they totaled up their legal fees, their unpaid interest, their loan losses, and their real estate broker fees and went after people individually.

 

So by not dealing with this sort of problem yourself, you may end up worse off—the Bank is selling your home when everyone else is selling, which depresses prices further, (in real estate, you make money by buying low and selling high which is easy to say but hard to do) and you may end up paying for things ‘twice’. First, you have lost the equity in your home and, second, you may still end up paying all of the Bank’s costs anyway. The only way out is to declare bankruptcy (which many of them did) but this could worsen your situation too—more on this later.)

 

Appraisers usually get paid $150 to $250 for run-of-the-mill home appraisals.

 

But Morris (not his real name) told me he had developed a new specialty—the 24/48 hour ‘rush’ appraisal for $500+, more than twice what he normally gets for a home appraisal. He told me that he has a special team of elite ‘SWAT’ type appraisers (a LOL comparison, I thought) who did these rush assignments. Why on earth I asked him, would anyone need such a thing?

 

Well, it turns out that Ottawa-Gatineau has two Casinos; and there are storefront lenders near these places that lend money to (compulsive) gamblers. These are not banks; these are openly controlled by criminal elements and their rates of interest including the vigorish (or ‘vig) are above the legal limit set in Canada (currently something like 60% p.a.) Their rates including all their ‘fees’ are way above this limit.

 

Now, Morris told me he has a new middle class, middle aged type of client who needs 24/48 hour appraisals because, if you don’t pay these loans back, they don’t send the Bailiff over to your house to put you and your family out on the road and take your possessions, they send other types of people—even scarier than Bank special loans officers or Bailiffs, much scarier. So Morris’ ‘special’ appraisals then are submitted to an American Bank (AB, not the real name of the institution either) that has set up shop in Ottawa to exclusively offer ‘home equity’ second mortgage loans of up to $100,000 in less than 24 hours. Their rates and fees are also atrocious but less than the legal limit and it’s better to owe AB money than these other people.

 

OK, so you’re saying: “It can’t happen to me” or “I don’t have a problem with drugs, alcohol or gambling”. Well, bully for you.

 

I think the number one cause for divorce is none of the above—it’s probably financial problems. Yes, I know that people say ‘I didn’t love him anymore’ but I’ll bet the root cause of many marriage breakups is financial stress and not that you really fell out of love with him. If your kids aren’t getting the opportunities you want to give them, if creditors are calling you at all hours, now that’s stressful.

 

Interestingly, over 80% of proposals for marriage come from the man asking the woman; the reverse is true for divorces. Draw your own conclusions.

 

Paradoxically, while I believe that the number one root cause for family breakup is financial stress, I also believe that the number one reason for financial hardship is marital breakup. It’s a circular argument but probably true. The nexus of a society is the family; if parents stay together, it is my belief that this affects, in a positive way, the social well being and the financial well being of the next two generations. The single largest class of poverty-stricken folks is single mothers. Need I say more?

 

Other obvious causes of financial hardship include: job loss, loss of a business, insured losses (losses where the insured value is less, often much less, than the replacement cost—and don’t get me started about the insurance industry*), loss of markets, loss of a large account, entry by a new competitor, illness, a change in your marketplace, inability to collect receivables, a default on a loan owed to you, loss of hope.

 

(* Former (now deceased) Chief Justice of the Supreme Court of Canada is reputed to have said ‘the insurance industry is one where large companies take advantage of smaller ones and individuals’.)

 

If a large client of yours or a large client of your firm goes bankrupt, your ability or your company’s ability to collect a receivable may drop to nil. The knock-on effects of this type of event can often be devastating and while, most of the time, if you want to know who is at fault when you are in financial difficulties, you just need to look in the mirror, sometimes, the fault is not yours.

 

Having said this, if one of your clients is getting into trouble, you usually have some inkling about it and you should be taking steps to avoid going broke yourself by diversifying your client base, for example.

 

So in the end, for most of us who face financial difficulties in our lives, the first thing to do is stop blaming everyone else. It doesn’t matter if someone didn’t repay that loan you made to him or her; if you can’t collect it, too bad. Get on with the rest of your life. This brings us to the last cause I mentioned: loss of hope. Human beings can not live without hope. If you have lost hope, you will never climb out of debt and you will never creditor proof yourself.

 

The Personal Bankruptcy Option

 

Many executives I have met in the US have proudly told me stories of how they had turned around companies in financial difficulties by taking them into Chapter 11 proceedings, a form of bankruptcy protection afforded stricken companies in the US that have some hope of emerging from bankruptcy protection with some viable subset of operations. I think they have a right to be proud of at least some of these turnaround situations—by getting rid of unprofitable operations and unproductive employees, they have at least preserved some jobs and given markets to at least some of their suppliers too and met some on-going demand from their customers as well.

 

And for employees, who have been laid off, I have seen many go on to more productive and happier work lives elsewhere. But I can tell you, I have never met a US executive who has told me about their personal bankruptcy. Now that is something entirely different. I tell my students at Carleton University in Ottawa, never, never let yourself go into personal bankruptcy if you can in any way prevent it.

 

In the British tradition, personal bankruptcy is a personal disgrace. I don’t think of it that way, but many people do. However, there are many, many things you can not do if you have been personally bankrupt which may include: teach (!), be a member of a police force, have a job where a security clearance is required*, get a credit card, get a cell phone, visit some countries, be a Director or Officer of a publicly traded company, become a professional like an Accountant, buy on credit, get a mortgage and more besides.

 

(* I suppose you can’t get a security clearance because the concern is that you could easily be bribed to reveal confidential information. When you are in serious debt trouble, or so the thinking goes, you are considered potentially unreliable.)

 

Now you may be told that you can skate out of your debts by declaring personal bankruptcy but that may not be true either. For example, you can not get out of paying alimony in Ontario by declaring bankruptcy.

 

You may be told that you can get a complete discharge from bankruptcy after a few years or even months and your record will be wiped clean. I believe that is total bunk; there are data havens that exist where your information will be kept and your personal bankruptcy will follow you around like a bad disease, forever.

 

It will come up over and over again—it will haunt you the rest of your life.

 

And there’s worse. I think if you declare personal bankruptcy, you end up paying three times. Yes, three times over. First, you will have to pay the court appointed Bankruptcy Trustee to oversee and manage your affairs (there, you have a new boss). Second, you will not be discharged from some of your responsibilities anyway (like say your alimony payments or the Judge may decide that while you don’t have any assets left, you have good earning potential. So she or he may decide that some of your future earnings will be set aside in a pool for your creditors; so, guess what? You end up paying them back anyway). Thirdly, after your personal bankruptcy, try getting a telephone hooked up. There are services that exist for people like this. A residential telephone service for people with bad credit will cost you twice what you would pay to Telus, Bell Canada or Verizon… and they won’t allow you to make any long distance telephone calls either. So now, you’ll pay higher costs for everything.

 

So when someone tells you, you should declare personal bankruptcy, hold your horses and, at least, think about it a bit before plunging off that particular cliff.

 

Now I am not counseling anyone to do any particular thing in this essay—I can offer no advice. But what I can do is at least raise some issues that might help you consider your options.

 

I personally believe that bankruptcy should be an option and should not involve any preconceived notions that you are a bad person. Everyone can make mistakes. I believe that everyone deserves a second chance. When I served on the NHL’s Board of Governors, I believed that the NHL’s drug policy should allow players a second chance. I believed that any player that came forward and admitted they had a problem with legal or illegal drugs should get counseling and support from the League, no questions asked. (Mind you, I also don’t believe in third chances.)

 

Imagine if personal bankruptcy resulted in your execution. How many people would go into business for themselves? How many people would want to be an entrepreneur? None. Bankruptcy should be a means of last resort but it should also be a means to restart your career. I know from a life of entrepreneurship that we learn far more from our mistakes—so we mustn’t throw these people away (sure we don’t execute them or send them to the poorhouse to work in exchange for their debts anymore but we kill them just as certainly by ruining their credit ratings).

 

How to Get out of Creditor Hell

 

I wish I could give you a simple recipe that is quick and painless. I don’t think such a thing exists. But one thing I do know that if you don’t get control of yourself, you won’t get out of debt.

 

If you drink too much, stop doing it. If your health is bad because you smoke like a fiend, eat too much, eat the wrong type of stuff, take drugs, gamble excessively, watch too much TV, don’t get any exercise, well, darn it, fix it.

 

Huh, you say, how is this related to the fact that you’re in debt up to your eyeballs? Well, I know if you drink a lot, you are NOT going to be at your peak and you need peak performance from your body and mind to get out of debt.

 

I tell people before they become entrepreneurs to be prepared to work hard, very hard over a long period of years. There is no substitute for this. Some of my students read about the guy who sketched a business model on a napkin and sold his company (which had no revenues and no clients) 18 months later for $120 million USD. Well that is about as likely as you winning the lottery. I tell my students that you can plan to get rich but you can’t plan on winning the lottery.  So don’t pay any attention to these types of exceptions—most of us, virtually all of us, who will have any type of financial success, will do so from concerted effort over considerable periods of time measured in years or decades.

 

Terry Matthews told me that it took him 7 to 12 years to build a great business and he has done it more than once (Mitel and Newbridge come to mind). So if it takes Terry 12 years, it will probably take you longer.

 

Once you have realized you have a debt problem and you have gotten control of yourself, what’s next? I suggest the next step is to look at how you can lower your costs. For a guy like me who has spent most of his entrepreneurship career on the revenue side of business, this is a latter day conversion. I now realize that no matter how buoyant your revenues are (either personally or corporately), if you can’t control your costs, they always rise to exceed your revenues.

 

One chap I know who makes a fabulous living working for a Fortune 100 corporation got into trouble in the year in which he made the most money of his career. We’re talking about a person who made more than $40 million in a single career-best year. How is that possible—well, he and his spouse collect rare artifacts and they overspent in a number of private auction sales. He ended that year with a horrendous tax bill, which he couldn’t pay.

 

So even if you’re mega-rich, you have to hold down your costs.

 

Now for most of us, it means doing some simple things like:

 

·       reducing the number of phone lines you have,

·       having a home office instead of a plush office downtown,

·       doing our own filing instead of hiring a clerk,

·       answering your own phones,

·       sending your kids to public school instead of private school,

·       taking a nice GoTravelDirect.com holiday to an all expenses inclusive resort in the DR for $899 a person including airfare instead of staying at the Kahala Mandarin Oriental Hotel in Waikiki,

·       visiting a qualified, trusted Mortgage Broker and renegotiating your home mortgage interest rate,

·       visiting a qualified, trusted Mortgage Broker and increasing your home mortgage in order to pay off high interest rate credit card balances,

·       freezing your credit cards*,

·       selling your home and downsizing,

·       turning off lights in your home,

·       lowering the thermostat,

·       getting rid of premium cable services,

·       getting rid of cable,

·       reducing the number of dinners out,

·       brown bagging your lunch,

·       planning your day to become more efficient with your vehicles,

·       buying gas when it’s cheap,

·       maintaining your vehicles so they last longer—doing preventive things like remembering to change the oil once in a while,

·       doing minor house repairs and routine maintenance yourself,

·       etc.

 

(* A lawyer friend of mine told me that he and his spouse have actually frozen their credit cards in a plastic dish. Every time they want to use one, they have to take the dish out of their freezer and wait for it to unfreeze. This delays their purchase by some hours or as much as a day. By that time, they usually have thought the better of it and return the dish to the freezer. I realize it sounds hokey but it works for them.)

 

I am sure you can add a hundred more things to my list but you get the picture. Note that most of the things on my list will find you doing more for yourself—so again that means getting up earlier and working longer hours so you need to be fit. When I talk about fitness, I don’t mean peak fitness like, say, a Brad Pitt or a Jennifer Anniston must look to. They get $10 to $20 million a film and their entire job is to look good. Please, don’t compare yourself to folks like this, you’ll only be disappointed. I mean lifetime fitness, which means a little bit of fitness (something that you do and will keep doing for years and decades), a care about your diet, not too much drinking and so on. This you CAN do.

 

Now the other side of the equation is the revenue side of your life. Some questions you might ask yourself:

 

·       Can I ask my boss for a raise?

·       Should I look for a higher paying job?

·       Is there anything else I can sell?

·       Should my spouse take a job outside the home?

·       Can I start a business that will make us more money?

·       Should I get a second job?

·       Can I add to our income by doing some consulting?

·       Can I make more money by stopping some of the things I am doing and concentrating on the best opportunities? (My Dad called this ‘supporting the winners and dumping the losers’.)

 

There are usually some things you can do on the revenue side of your life but usually it is pretty small, at least in the short term. So I typically tell people to focus first on immediately reducing their cost structure. Hey, I find that once you get into it, it can really snowball.

 

There is a huge movement in North America right now focused on simplifying your life. Do you want to know the number one thing you can do to simplify your life? Get out of debt.

 

The Europeans laugh at us sometimes—they call us the ‘work/pajamas people’. We work all the time, come home, change into out pajamas, go to sleep, only to do it all over the next day. That’s it, that’s what most North Americans are doing, with some mindless TV watching to help us get off to sleep so we can forget what a misery our lives are.

 

We live to work, the Euros work to live. I mean what is the purpose of an economy anyway—to give us money to educate our kids, to give us the opportunity to do interesting things and learn interesting things ourselves too? Or is it so we can work all the time to pay our bills?

 

Whatever you do, don’t ignore your creditors—they hate this and will definitely report you to their credit bureaus, which will kill your credit rating in a hurry (more on this in a minute). When they phone, be polite, tell them what steps you are taking to pay them (even if you are late) and then live up to what you said you would do.

 

Now at the end of the day, maybe you just can’t get out from under the heap of debt. What to do? Well, I have asked you to at least pause before you declare personal bankruptcy because of the serious consequences that I believe result from that drastic step.

 

But I have found that if you are honest with your creditors, at least some of them will cut you some slack. In business, your suppliers don’t want to see you fail—they like having customers to sell to. So, for businesses in trouble, one of the first places you go to is your suppliers.

 

Now this can backfire—they may instantly cut you off. It’s a risk.

 

When I was with Terrace Investments Ltd., we had a policy of not kicking our tenants out when they had a financial problem and not suing them either. We felt we would get much further ahead by working with our tenants—lowering their rents by agreement during tough times and getting it back during better times. We estimated that we saved about 40% of our tenants from the dustbin that way and we NEVER wasted any time suing bankrupt tenants that went broke—we had better, more positive and productive things to do than engage in soul-destroying litigation*.

 

(* Samuel Adams I think it was who said (and I paraphrase here): “If a man should steal my watch, I shall fight him for it. But if a man should sue me for it, I shall take it off and give it him, glad to have gotten away so cheaply.’)

 

So sometimes you can make a proposal yourself to your creditors and have then accept longer payment terms, lower interest rates or even get their agreement to take less than face value on your debts.

 

On the other hand, some residential landlords when they hear you are in financial trouble will take immediate punitive steps against you—like try to evict you or distrain your premises. (The latter is a term you see more frequently in commercial real estate. Basically, it means that the Landlord can lock you out of your premises and seize everything inside as recompense for their unpaid rent.)

 

I realize that making a proposal (whether you do it yourself or get expert help from a recognized, trusted professional) is risky but I am assuming that you are out of other options. And you have gathered by now that I believe you are probably better off most of the time to make your own decisions and handle your own affairs.

 

And I have found that if you are honest with people, most of them will cut you some slack. When I started out in business in 1982, a smart lawyer by the name of Kent Plumley told me that the most valuable thing in business was your reputation. I didn’t really get it then but I sure do now. If you have a good reputation, people will hire you, buy from you, sell to you and, when you get in trouble, help you as best they can. I believe that the number one thing in life is not love; it’s trust.

 

Still, I have known Banks that just get a whiff of trouble and they’ll pull the trigger on your loans (they ‘call’ your loan, i.e., demand immediate payment in full) even though you may not have even missed a payment. They do this so they can be first in line to grab what they can from your estate (a bankruptcy estate is not the same as the estate you leave on your passing but I can see how sometimes it feels that way). They absolutely shouldn’t do this but if you look at most of the personal Bank lines of credit agreements and other types of debt agreements, the Banks usually have a lot of weasel words in there that pretty much allow them to do what they want.

 

When you have a big debt problem, one of the things you can try to do is a debt consolidation. This can be done informally (like when you re-mortgage your house to pay off your credit cards) or formally through a proposal to creditors (which you will need legal and professional help to do).

 

The latter is a kind of delaying tactic—you are trying to feed an elephant but only one peanut at a time.

 

Remember that you must change things—whatever you have been doing, it isn’t working. I can’t tell you how many people seem to be frozen in the headlights when they see a debt problem coming at them but refuse to change what they are doing*. You must act.

 

(*It is the definition of insanity to repeat the same things over and over again and expect a different result,” Anon.)

 

What to do if You or Your Company is Petitioned into Bankruptcy

 

Fight it, especially if it’s personal bankruptcy. I believe that it is hard and maybe even impossible to fully recover from personal bankruptcy. If a vindictive creditor just wants to hurt you, they may try to petition you into bankruptcy. You don’t have to accept that.

 

This will be a court proceeding and you will need a lawyer but you should appear and argue against this if you can. I believe that most judges will be somewhat sympathetic to someone who wants to repay his or her debts; is making efforts to do so and wants to avoid the stigma of personal (or corporate) bankruptcy.

 

I have also found that meeting face to face with your most difficult creditors is generally a good idea—they see that you are not such a bad person after all. They will see your pain up close. You are far more likely to work out a deal if you can get an in-person meeting than if you have your lawyer talk to their lawyer. In most cases, their lawyer doesn’t want to settle anything. They make money by dragging the case on and on—lawyers usually get paid even if no one else does*.

 

(* I find it frankly incredible that NHL owners and NHLPA members are allowing two lawyers to attempt to resolve the current labour dispute that is on-going as I write this. Both Gary Bettman and Bob Goodenow are well trained, combative lawyers and, if I was ever in a jam, I could do a lot worse than having either of these two men defend me. But I can’t imagine how the League and its Player Association will ever come to terms unless League owners and Players sit at the table along with Bettman and Goodenow.)

 

I have seen hardhearted creditors melt in these kinds of meetings. It also gives you an opportunity or your lawyer an opportunity to tell them that even if they got a judgment against you (which you will defend), they still have to enforce it and that may not be easy. A lot of people don’t know that just because they have won a court case and have a judgment against you, they might not actually receive anything for it. A judgment can be appealed. A judgment that is upheld must be enforced. First, there will be a debtor- creditor examination to see if the debtor has any assets left. Then, the creditor has to find a means to collect on his or her judgment—the Government and the Courts won’t do that for them—they are on their own. So an expensive court proceeding that can take years may be worthless even if they win. Much better to get the cooperation of the debtor who might be able to make at least partial restitution. And that restitution might not be in the form of cash or assets—it could be in the form of services. You could work for them!

 

A friend of mine called me up a few years ago in tears. Kevin (not his real name) was incredibly upset—the Bankruptcy Trustee (called in by his Bank unexpectedly) had just entered his premises and was in the process of taking over his business and his files. His Bank had told him that they would give him notice if they were going to do anything precipitous. They didn’t but I can understand why most of the Special Loans Bank officers don’t want to give people like Kevin any notice—they are afraid of last minute fraudulent transactions to remove assets or cash from the business.

 

But Kevin wasn’t like that; he was still working hard to save what had been a very successful financial services company. The Company was knocked over by a single (large) transaction that had gone south. Many good businesses are ruined by they themselves not being able to collect their receivables.

 

Kevin asked me: “What do I do? They’re at my door asking me all sorts of questions, demanding answers from me right away!”

 

“The first thing you do, Kev,” I answered, “ is nothing at all. I want you tell them the (smart) truth*. Tell them you’re very upset right now (which is true) and you will fully cooperate with them. Tell them you’re sick about what has happened but that you have to go home right now. Then just take your personal effects and leave immediately.”

 

(* I learned from another clever lawyer, Scott MacLean that one must always tell the truth but it must be the smart truth. No one expects the truth anymore in our media saturated society. The smart truth keeps you out of trouble. The truth hangs you. How you say things makes a huge difference. Here is an example—Coke came out with a vending machine a few years ago that adjusted soda prices when the weather changed. They also came out with a media release that basically said ‘we have invented a vending machine that raises soda prices when it gets hot.’ You can imagine how that went over: ‘large company denies thirsty customers on hot days’. The smart truth would have been to say: ‘we have invented a vending machine that lowers prices on cold days’. Same thing but completely different result. The spin on this would have been: ‘Company cuts customers a break on cold days’. Coke’s new vending machine has never been rolled out.)

 

One thing that happens in our society when things go wrong is that we always want to find someone to blame. And that someone is you. I told Kevin to call me from home. Here is what I told him the next steps should be:

·       Call the Trustee the next day and arrange for him to send you a list of questions that he needs help with.

·       Take the initiative.

·       Offer to help.

·       However, never answer their questions off the top of your head.

·       They have done this dozens, maybe hundreds of times and they know how to think around corners. You have done this (hopefully) never. Therefore, it is a very unequal playing field and likely to result in a very unequal result.

·       Remind yourself that they are not your friends.

·       Remind yourself that they may be trying to trap you into saying things that incriminate you even though you have done nothing wrong.

·       Answer their questions on paper first. Then sit on your answers for at least 24 hours.

·       Read them again. See if they still make sense.

·       If you can’t handle it yourself, get a lawyer.

·       Don’t get bullied or rushed into premature answers. Tell them you’re trying as hard as you can to get all the info they need.

·       Start by giving them something innocuous to show that you are cooperating and this will buy you some time.

·       Remember what happened to Patty Hearst—she not only got captured by the Symbionese Liberation Army, she was brainwashed into becoming a gang member. This is known as the Stockholm Syndrome, which means that any of us can be forced to do things we would normally abhor if we are under sufficient duress.

·       If people keep telling you, you are a bad person, you may eventually come to agree with them even if you did nothing wrong. (This entire essay is based on the fact that you are a trustworthy person trying to get ahead honestly in the world but, like everyone else on the planet, you make mistakes of omission.)

·       This is what Crown Attorneys (District Attorneys in the US) count on in a cross-examination—that they can brow beat and rush you into damaging admissions. Even experienced, professional witnesses feel intense stress during these types of crosses.

·       You would be surprised what people will admit to—even things they did not do just to get them to stop.

·       You never let people like this put words into your mouth. Don’t repeat bait words like: “Isn’t it true Mr. Smith that you paid bribes to City officials to get your permits released?” You don’t answer: “I never paid bribes” because the next question will be: “Well, Mr. Smith, if you don’t like the word ‘bribe’, what word would you use?” You can see where this might take you. The smart answer is: “We have records and invoices from the City for all of the costs for our building permits.” The word ‘bribe’ never passes your lips.

·       Remember the ‘pen is a long arm from the grave’. Never write anything down that you would not feel comfortable seeing on the FRONT page of your local newspaper.

·       This goes for email too.

·       Especially for email.

 

I also talked to Kevin about some other stuff too. I told him that I would allow him to feel sorry for himself for three days. The first day, you are allowed to drink some wine or whatever and wallow in self-pity. The second day, try to get some extra rest. The third day, I want you to get some exercise. By the fourth day, apart from trying to deal with the fallout from your company’s bankruptcy (which can go on for years and you are just going to have to learn to live with), I want you to start planning your new future.

 

Your Credit Rating

 

Now if you owe money to the IRS or CRA (in Canada), you should know that this is very serious. In Canada, CRA can get an ex parte judgment against you—this means that they can get a judgment against you without you being in court or even being notified of the fact that a legal proceeding has taken place. This is atrocious. Common law suggests, at least to me (and I am not a lawyer so this is just a lay person’s opinion), that taxation without representation is immoral and held to be illegal. For you not to be at least notified and have an opportunity to defend yourself against the claims of your own government is disgraceful.

 

With a judgment against you, they now have the power to ruin your credit rating, to send a bailiff in without notice to take your stuff, to garnishee your wages from your employer, to seize any property you have and much more.

 

If you credit rating is torpedoed, you’re sunk. Your spouse won’t be able to go get that new tool he wanted or the new fridge she wanted OAC (On Approved Credit) because your Beacon Score (how most credit agencies rate you) has fallen too low.

 

Credit bureaus are hugely powerful—they keep track of all your credit cards, your mortgages, your Bank debt and much more. Privacy in Canada and the US is a joke—you have none.

 

Anyone who is a member of a credit bureau can request your credit history (called a credit report) and they are going to know a lot about you. Did you know that just the number of requests that are made on your credit rating lowers your Beacon Score*? So if you just sold your condo and your old car to move your family into a new home, buy a new washer and dryer, a new fridge, a new car, some curtains and some other nice stuff OAC or if you approached a few Banks for a mortgage (and each of them will query your credit report), your Beacon Score just took a big hit. Huh? What’s with that? Isn’t that what the big box stores, the car dealers, the Banks, the Government want you to do? Isn’t that what your Mom and Dad told you to do when you grew up—be responsible, get a house in the suburbs, have a couple of kids, drive a nice car?

 

And your credit rating goes down! What a …. (I can’t say it in polite company.)

 

(* Every time someone ‘pings’ your credit report, your Beacon Score will go down by 3 points. If you have a lot of involvements (e.g., you are an entrepreneur with fingers in a lot of pies and you are busy starting new ventures, developing new technology and new ways of doing things, building new facilities, creating lots of jobs—i.e., doing the things that entrepreneurs should be doing), then there could be many requests for a credit report on you. Every time you do a new financing, your credit rating could go down. Not only is this unfair, it actively works against society’s best interests as well as the individual’s. This practice should stop, in my opinion.)

 

Now if your credit rating goes down, everything becomes more expensive—you can’t take advantage of that don’t pay a cent event until…. No interest until…. You have to pay cash for everything or if you borrow money, it will at a higher interest rate.

 

Ken MacMillan was right all along. If you can manage it, don’t borrow money and live within your means.

 

Having said this, you have the absolute right to demand from each credit bureau (there are two main ones in Canada), a free copy of your credit report. They must provide you with one. And I have found that it really pays to pull your report from time to time—they make mistakes and have out of date info on file and you must correct these. Never allow something to stay on your credit history that is wrong.

 

It takes a huge effort to get the credit bureaus to change something that is out of date or is wrong but you must be persistent. A bad credit report is a career killer and a business killer.

 

So monitor your credit report and do things that will improve your Beacon Score like retire your credit cards, pay off your back taxes, etc*. Your score will go up over time as you gain control over your financial life.

 

(* To give you a sense of how important this is, a friend of mine who works for a major Bank in Canada tells me: “I have witnessed how quickly the Bank will terminate credit products if the client is deemed to be too high risk—even if they have made ALL of their minimum payments. Working there, I have also seen first hand how difficult life can be for people who have declared bankruptcy or those who have unsatisfactory credit history.”

 

Banks have any number of ways they can ruin your credit rating. One of the most abusive I have ever heard of was brought to my attention by a Small Business Owner—he called me in some distress to tell me that a crucial order for materials had been derailed when his cheque was returned to his supplier, NSF (Not Sufficient Funds). He couldn’t believe it. I had just helped him sell a piece of real estate he owned. The net proceeds from that sale were to be used to expand his business. He had received a certified cheque from his law firm’s trust account drawn on a major Canadian Chartered Bank.

 

Now a certified cheque in Canada is treated the same as cash. Huge transactions occur every day based upon Bank certified cheques—not just real estate closings but purchase of shares in a corporation, mergers and acquisitions and a thousand other types of financial transactions depend on the sanctity of certification. National economies like Argentina’s where the banking system has unraveled (circa the early 2000s) and all transactions have to be in cash suffer greatly from a lack of trust and the speed at which business can take place is reduced. Speed is one of the most critical factors that determine a nation’s productivity and its standard of living.

 

(It is actually against the laws of Canada not to inform a client that a hold is being placed on their cheque. A Bank in its defense might say that they put a hold on a certified cheque to enure it was not stolen or altered. Banks are particularly concerned with large cheques but, almost by definition, certified cheques will be for larger amounts than run-of-the-mill transactions. What will this mean for Canadian commerce if the practice becomes more widespread? I am sure it will not be good for Canadians.

 

I think that every city economy (which is really a city-state in the sense that, for most people these days, your economic well being is probably far more tied to how well your local economy is doing than the national or global economy) has a certain ‘speed limit’ attached to it. That is, the maximum speed at which a local economy can move is limited by many local factors such as how fast your lawyer moves, how fast your local financial institutions react to your requests for financing, how fast your customers make up their minds, how fast your suppliers can move, etc. My perception is that business moves a lot faster in Hong Kong, NYC and Singapore than it does in Toronto or Sydney. And Toronto and Sydney move a lot faster than folks tend to in places like Ottawa and Vancouver say. Anything that increases speed in your city-state will increase overall productivity and increase overall financial well being there. The reverse is, unfortunately, also true and having Banks put, say, a ten day hold on certified cheques is problematic.)

 

Back to Paul’s (not his real name) story, his Bank had put a hold on his deposit for ten days while the certified cheque ‘cleared’. I was flabbergasted and offered to call his Bank for him right away. I spoke with the Branch Manager. I told her: “This is highly unethical and might even be illegal. How can you do this to Paul? On what basis have you put a hold on a certified cheque issued by one of our largest, most prestigious law firms and a major Canadian Chartered Bank? What are your concerns? Have you done this to other SMEE clients? Is this a policy of your Bank? What are you going to do to make it up to Paul?”

 

She agreed to release the funds immediately but did nothing else. Paul had to make amends with his supplier and he was lucky that he wasn’t reported by his supplier to the credit bureaus. Passing NSF cheques is a big no-no but it can happen to anyone.

 

I was pretty sure that this was an isolated incident until two more SMEEs told me the same thing happened to them. This is atrocious behaviour on the part of Canadian Banks.)

 

Even if you have bad credit, over time you can rehab your rating. I tell my students to absolutely not declare personal bankruptcy when they graduate because they have way too much student debt but sometimes, it happens. I may not see them until years later when they are starting their own businesses and have not awoken to the fact that they have bad credit and can’t get say supplier credit.

 

This is not good.

 

So I tell them to re-establish their credit by taking some small steps in that direction. For example, I tell them to get a credit card (yes, I really do) but one with a really low limit. And then use it from time to time on absolute essentials and pay off the full balance every month.

 

Credit card companies may allow someone with bad credit to have a credit card by establishing a cash collateral account and clearing the card regularly. For example, a friend of mine who recently went through a formal, court-monitored proposal to her creditors managed to keep one of her credit cards by informing her Bank in advance of the filing. They agreed to allow her to keep one card with a $3,500 limit, which they cleared every Thursday against a cash collateral account that she maintained at $5,000.

 

She is a high earning professional who had made some terrible investment choices. She travels a lot in her business and, for her, a credit card is an essential tool.

 

It takes time but you can rebuild your reputation

 

The Proper Role of Debt

 

I also teach in the School of Architecture at Carleton University. I teach Design Economics and Enterprise of the City there. One of the things I recommend to my students is that they buy their own homes, condos, town homes, whatever as soon as they can. To do that, most of us need a mortgage.

 

A mortgage can be a form of useful debt—it allows you to buy a home sooner and is a form of forced savings. I ask my students how many of you can save $700 a month. Not many put up their hands. I ask how many of them can afford to pay $700 a month in rent. Most of them can manage this.

 

Well part of every month’s blended mortgage payment is going to pay off the principal and this will add up over time to a mortgage-free home. So let’s say that an average of $700 a month went into principal repayments over a five-year period, that’s $42,000 ‘saved’. Now most of us, if we had this in a bank account somewhere, would find ways to spend this money but because it is locked into bricks and mortar, we generally keep it.

 

Home equity is the most important form of savings we typically tend to have—it is easily accessed if we get into a jam by re-mortgaging the home and, around the world, it is the single most important source of capital for new business formation (far, far more important than Venture Capital).

 

Also, there is a little understood but important wealth effect that comes from paying off a home mortgage—it is called imputed rent. If you own a home free and clear, you are much better off than because of this (at least in Canada. In the US, mortgage interest is tax deductible (I believe the only country that does this) and this changes things somewhat.)

 

The way to understand imputed rent is as follows:

 

1.     You own a home free and clear.

2.     You decide to move out and rent your home out for $2,000 per month.

3.     But you need to live somewhere, so you rent a comparable home for $2,000 per month.

4.     Your former principal residence (now a rental property) is producing income for you and let’s just assume you net $24k a year (i.e., your costs are zero).

5.     However, you are in the 50% marginal tax bracket, so you have to send CRA half of this amount—you are left with $12k after tax.

6.     But you are paying rent of $24k a year to your Landlord so you are out $12,000 in CASH.

7.     Therefore, you are $12,000 better off staying in your principal residence. This is a very real effect* if somewhat hard to grasp.

 

(* Australia and Switzerland actually tried to estimate imputed rents and tax them. You can imagine the public reaction to that—you have been a good citizen all your life, you have invited your neighbors over for a mortgage burning ceremony only to find that the Government is going to tax you on a rent you don’t actually receive. These efforts run contrary to common sense and were doomed to failure. A home-owing citizenry is a group that has a stake in their societies and obviously putting elders out on the street because they can’t pay their taxes on imputed rents isn’t good public policy.)

 

So buying your own home using a mortgage is likely to be a good idea for most people—not all debt is bad. But buying a NHL hockey team with debt is probably a bad idea*.

 

(* One of the first things that new Commissioner Gary Bettman told me in 1993 was pay off the debt on the franchise. Hmm. That would have been good advice. I am better at giving good advice than taking it.)

 

How to Reduce Your Risks and Protect Your Family

 

I have already said that, in my view, you don’t protect your family by hiding your assets on Pirate Island. This will lead to huge distrust amongst folks like the IRS or CRA, the media and many others (your ex-wife or ex-husband, for example). My father always told me: “Be proud to pay your taxes in a great country like Canada, but don’t pay more than you have to.” The latter part of the sentence was always told sotto voce.

 

So you are completely free to arrange your affairs in a way that is efficient and effective, as long as it is legal and simple and meets GAAP (Generally Accepted Accounting Principles). The legal and GAAP part, I will largely leave to you to figure out (with help from professional lawyers and accountants). The simple part needs more elaboration.

 

I always laugh when I read in the media that people (i.e., NHL Owners) are buying their teams for tax loss purposes. NO ONE SHOULD EVER BUY ANY BUSINESS TO LOSE MONEY.

 

I think we waste an incredible amount of resources and time, trying to figure out ever more complex schemes to avoid paying taxes—this is called financial engineering. Every financial engineer I have ever known eventually went bankrupt. They engineer such incredibly complex transactions that eventually no one really knows what is going on. Human beings constantly overestimate their intelligence and complexity is the enemy of success.

 

So rule number one—keep your affairs simple. The best way we have yet discovered to hold assets for long periods of time is the LLC—Limited Liability Company*. Apart from a few institutions that are bound together by ‘other directed’ means (like the Holy Roman Catholic Church, The Emperor of Japan or the House of Windsor), the longest lived organizations on the planet are incorporated companies.

 

(* Most of my students think that a LLC is just that—it totally limits your personal liability. It does put some limits on your personal liability but it is not a 100% guarantee. Your company’s creditors can, in certain circumstances, breech the wall of limited liability. In Ontario, for example, Directors and Officers may be held personally liable for environmental contamination or non-fulfillment of statutory obligations like remitting GST (Goods and Services Taxes), PST, income source deductions and so forth. In order to avoid such personal liability, Directors must show that they have been duly diligent, like remembering to ask at each BOD (Board of Directors) meeting if such statutory obligations have been met. And remember, the due diligence defense never applies if fraud is involved and you have been party to it. In the US, personal liability has been further extended to include the accuracy of financial statements for public companies. Investors large and small rely on these published statements, so they have to right.)

 

So I tell my students, start early: incorporate a personal holding company (PHC) and put your assets in there except for your principal residence. Because in Canada you can sell your principal residence tax free, it should not go into your PHC.

 

I believe that your principal residence should go into your spouse’s name—the spouse who is not actively involved in high-risk business. In Ontario, if you get divorced, half of everything you own goes to your partner and vice versa. So don’t worry about your partner running off with the house. Try to put your home out of the reach of any potential creditor so if things go wrong, at least you’ll have somewhere to sleep.

 

Don’t pledge your house to secure loans if you can avoid it. Try to pay off your mortgage as soon as you can.

 

Your creditors (in Canada) can get at your RRSPs. So make sure you max out your spouse’s RRSPs before your own.

 

I understand that some types of insurance products (like seg (segregated) funds) are creditor proof but don’t ask me to explain them or whether they are a good investment. Ask a trusted professional investment advisor*.

 

(* Most of my entrepreneur friends are really good at taking care of their businesses and really bad at taking care of themselves. So I asked Sandra Pollack, a knowledgeable and trusted financial planner from TRIMARAN Financial Limited (sandy@trifina.com) for her help in understanding seg funds and pensions for entrepreneurs. Here is what Sandy wrote:

 

“Many entrepreneurs ask me if there is a way that they can protect their RRSPs from creditors and/or taxes and the answer is yes and no.  Segregated funds have been often discussed as means of doing this.  I will attempt to highlight what these funds are, the advantages and disadvantages of including these as part of an investment portfolio, and then perhaps an informed decision will be able to be made.

 

Segregated funds are pools of securities that are managed and offered by insurance companies.  These contracts are regulated by the Provincial Insurance Acts.  As such, they enjoy benefits such as probate protection, the potential for creditor protection and capital guarantees that are not available with common mutual funds. These plans can be in the form of term deposits or mutual funds.

 

As these are considered life insurance contracts, with proper beneficiary designations (e.g. Parent, spouse or child), also known as preferred beneficiaries, these funds may also be distributed outside the estate at the death of a person and paid directly to the beneficiary.

 

Under provincial insurance law, life insurance annuity contracts issued by life insurance companies are exempt from execution and seizure by creditors of the policy owner if there is a preferred or irrevocable beneficiary designation.

 

While there have been many attempts to challenge this “protection”, the Supreme Court of Canada has confirmed that these funds may be exempt from seizure with the understanding that the transaction of depositing these monies into segregated funds was not carried out in “bad faith” in order to avoid creditors.  Although each individual case may be challenged, it depends upon the surrounding facts and circumstances.  The courts may look back five years to determine that no bad faith has occurred.

 

For example if John Smith, a successful entrepreneur, who has been in business for 10 years and has consistently contributed to an RRSP in the form of segregated funds, is forced to declare bankruptcy, there is a very good chance that his funds would be exempt from creditors.  If John had never invested in segregated funds, was aware of current financial challenges that the business was undergoing and decided to transfer his RRSPs into segregated funds a year or two previous to declaring bankruptcy, the funds would more than likely be challenged by creditors and be seized.

 

As such it would be wise to start investing in a segregated fund from day one to avoid potential challenges, should a bankruptcy occur due to unforeseen future circumstances.

 

Another useful tool to have in your “creditor proofing” toolbox is an Individual Pension Plan (IPP).  This is a defined benefit registered pension plan that a company contributes to on behalf of the owner manager/employee.  The contributions are tax deductible to the company and non taxable to the employee (owner/manager).

 

This type of pension plan is primarily designed for the high income earners over the age of 45 who have a history of earned income of $100,000 (minimum). An actuarial calculation is used to determine how much past service and current contributions can be made on behalf of the individual, and in many situations, lump sum contributions of $60,000 or more can be deposited from the company in the name of the employee.  The calculations assume retirement at age 65; however, the funds may be withdrawn at age 69.

 

The plan must be registered with Canada Revenue Agency and is fully creditor protected since it is a bona fide pension plan. The costs to administer these plans have decreased significantly due to technology and the competitive market place.  For the right individual the IPP is an opportunity to redirect earnings from the business that are totally tax deductible and invest them in a pension to provide retirement income for the entrepreneur.  Since this is a pension, the funds are protected from creditors.

 

Many successful entrepreneurs are so busy pursuing opportunities and reinvesting capital to spur the growth of their businesses, that they often miss out on a couple of simple planning strategies, that will provide them liquidity and peace of mind when an unforeseen financial event has the banks and creditors closing in on their heels.  It may be wise to take the time to diversify income that the business earns and set it aside in a retirement pot as well.”)

 

You probably should own a very small percentage of your PHC; your spouse should own the majority. Again, if you get in trouble, the PHC may not go down the drain with you. Also, if you own only a nominal shareholding in your PHC, upon your passing, the taxes you will pay on the forced deemed disposition of your assets will be minimal. Your terminal tax return will not then leave an enormous tax liability for your heirs to pay, at least, not on this account. Remember, companies can live forever, you won’t.

 

If you have a home office for your PHC, some of the costs of running your home may be tax deductible.

 

If one of your companies has some success, you can pay inter-corporate dividends between two Canadian companies tax-free. So you may be able to find efficient ways to get money into your PHC and out of your PHC into the hands of yourself or your family.

 

For example, you or your spouse or both might become consultants to your PHC. And your PHC might be a consultant to your clients. Often a first step toward full on entrepreneurship is to turn yourself into a consultant instead of an employee. I was last an employee in 1982 when I worked in the Department of Public Works in Ottawa. I left government service that year to become a consultant for a few local real estate and service companies. This has certain advantages such as taking all your compensation with few if any source deductions and being permitted to deduct certain costs against your income such as the cost of running your home office, parking fees when you visit clients, entertaining clients, marketing and biz dev costs, etc. It wasn’t until 1995 that I finally clued in to the idea of forming a PHC which has made the last nine years a bit more productive.

 

Even after I became more of an entrepreneur in my own right, I kept the PHC going and consulted with the companies I was helping to start. At a minimum, the PHC certainly allows you to establish more control over, keep better track of and even leverage more of your investments.

 

If you think you have it tough in terms of risk exposure, look at what my architect students face during their professional careers. At one time in Ontario, architects were not permitted to incorporate—they worked in sole proprietorships or in design partnerships that exposed them to unlimited personal liability for malpractice. In addition, their exposure was not time limited; if a building they had worked on at any point in their careers developed problems, they could be sued no matter how much time had passed.

 

Under pressure from the OAA (Ontario Association of Architects), Ontario now allows architects to practice in incorporated firms and term limits their liability as well. LLCs and LLPs (Limited Liability Partnerships) can help to shield architectural practioners from some personal liability although they can never relieve shareholders, beneficiaries, practicing architects, retired architects, directors or officers from errors of commission. I don’t see any reasons why architects shouldn’t practice in LLCs and I would probably go one step further and suggest that they hold their shares in their LLCs in their PHCs, as long as this was permitted by their governing bodies in whatever State, Province or Country they may practice in.

 

In any case, every practicing architect or entity (such as a LLC) engaged in the practice of architecture must carry errors and omissions insurance (for example, as required in Ontario by the Architects Act RSO 1990). When things go wrong in construction, the plaintiff tends to sue just about everyone ever connected with a project including: the contractor, the sub-trades, the architect, the engineers, the investors, the mortgagee, you name it.

 

Many practicing architects may not think of themselves first as entrepreneurs (they tend to think of themselves, I believe, foremost as artists) but indeed they are. Like most writers, poets, novelists, painters, dancers, musicians, composers, videographers, screen writers and other creative persons, they are not paid every two weeks by an employer who not only ‘feeds’ them but protects them from liability and provides them with nice benefit packages and a pension plan. So they too need to think a bit about creditor protection so they won’t die broke (or at least, if they die broke, they did so out of choice).

 

There are many things you can do to try to protect your family and you should try to do this. Most entrepreneurs that I know are so focused on making their businesses succeed that they never do any personal or family financial planning and this is a shame because bad things do happen to good people.

 

At the very minimum, you should create a personal balance sheet (PBS) to keep track of the things you own. You can do this informally (if you know something about accounting) or formally with help from a professional accountant.

 

While not a formal legal arrangement like a LLC or a Family Trust, a PBS will help you understand what you own, what liabilities you may have incurred and maybe it will help you see opportunities you may otherwise have missed.

 

One of my former students, Claire (not her real name) had bad credit—she had a vehicle repossessed some years earlier for chronic non-payment. She had also defaulted on a credit card. She had matured a lot since then and, in fact, had started a successful computer service business. We got hold of the credit card company, she made good on the past debt and even received a new card too. She also made a deal with the finance company to make a partial restitution (which they agreed to) and clear the account with them. When we created a PBS for Claire, we found that services businesses like hers were valued at somewhere between .5 and 1 times revenues and even at .5, she had a very positive PBS with practically no debt. Within a year, she was able to purchase her first home.

 

Build and Hold—the Difference between Getting Rich and Being Wealthy

 

I read in October 2004 that Ottawa-base QNX Software Systems was sold to Harman International for $138 million USD. I know that some of my students and clients read it too and they will be thinking build something and sell it for A LOT OF MONEY. The only problem is that most of them might not read to page 2 of the Ottawa Citizen article (October 28, 2004) which says: “For Mr. Dodge, 50 and his partner Gordon bell, 49, the deal marks a vindication for their effort to build a profitable company without venture capital over 24 years.” (The emphasis is mine.)

 

I am not saying that you should never sell your business but what I am saying is that it takes time to build a great business.

 

People who build and sell quickly are known as flippers. Most of them flip ‘til they flop. If you have built a successful business, you have climbed Mount Everest twice. You have captured lightning in a bottle.

 

It is so hard to build a successful business, it takes so long to do it, you use up so much of your lifetime storehouse of luck doing it, that you should think very carefully before you sell it. Successful entrepreneurs often think: “Well, I did it once, I can do it again and again”. Bad news, people, often you can’t.

 

If you have built a great business, why sell it? What exactly will you do next? Start again? Why go through all the heartache and risk again when you already have a fine business you built yourself?

 

I didn’t feel that an essay on creditor proofing oneself would be complete without mentioning this trap that so many of us fall into. It’s called hubris.

 

One of the best ways to get out of creditor hell is never to get into it in the first place. One of the ways to do that is to not sell your successful business. In almost all cases, a successful business will sustain you and your family and your employees and your suppliers and your other stakeholders far, far better than cash in the Bank.

 

Let me tell you another story, this one about Sean (not his real name). Sean was a by the bootstrap kind of guy and he had one great thing going for him—he had charm. He was a born salesperson and in the game of entrepreneurship, if you can’t sell, you’re out of the game before you can begin. (The three most important things in entrepreneurship are SALES, SALES, SALES.)

 

Well, one day about fifteen years ago, Sean found himself working in the fish department for a large supermarket chain; he was wearing one of those hair net things and he was developing arthritis in his hands from the cold and ice he was constantly exposed to. He and his spouse, Freda, had their first child (of what would eventually be a clan of three kids).

 

Sean thought to himself: “I can do better than this.”

 

The next day he went out and bought himself his first computer (never having even booted one up before) and started an advertising and promotion business in his basement with nothing other than guts, charm and a high school diploma. (I have changed his industry too to protect their identity. I apologize to my readers.)

 

I met Sean one day, about two years after he started working out of his basement, and he convinced me to move our entire advertising and promotion account over to his company. He was that good. I certainly asked him about his bona fides. Could he produce the volume we needed? How was his Quality Assurance program? Yadda, yadda, yadda.

 

I didn’t know until years later that this was his big break—it allowed him to finally move his business out of his basement, buy more equipment, hire more, better people, etc. But when he told me, we laughed about it together and I was doubly glad—glad that he was a success and glad that he didn’t let us down.

 

A few years later, Sean called me out of the blue. He had an offer to buy his business from a larger competitor for TWO MILLION DOLLARS IN CASH. I told him to slow down and think about it a bit more. I asked him a few questions. How much are you taking out of the business? About $200 to $250k a year. How much do you pay Freda to do your books? Oh, about another $50k. Do you have any company cars? Yeah, reckon so—two of them in fact.

 

In total, Sean and his family were getting about $300,000 a year from the Company, year in year out—it was a sustainable number.

 

I asked Sean, do you know what interest rates are on term deposits right now? No. Well, they are about 1.7% p.a., which means that even if this sale was tax free, your income from your two million dollars is going to be 34,000 bucks a year and every year inflation is going to eat away your principal. Now why would you give up $300,000 a year and a business you love and built yourself for that?

 

Let me quote actor and comedian Chris Rock:

 

“Shaq (Shaquille O'Neal who plays for the NBA’s Miami Heat) is rich but the man who signs Shaq’s pay check is wealthy.”

 

Chris Rock got it exactly right. You can get rich by winning the lottery, becoming a NBA Star, speculating, asset flipping, gambling, picking the right parents or prospecting for gold, diamonds, nickel, whatever, but you can’t become wealthy doing any of these things.

 

Wealth derives from control over a factor of production, a license, a franchise, a territory, some IP (Intellectual Property like the secret formula for Coca Cola or the 11 secret herbs and spices that the Colonel uses to make fried chicken), a competitive advantage, a comparative advantage, property ownership—anything that creates a sustainable, repeating and renewable income stream.

 

Just look at the numbers; let’s say someone controlled the early Beatles catalogue (say, someone like Michael Jackson). Mr. Jackson is reputed to have bought the catalogue in 1985 for $47m (but he lost his friendship with Paul McCartney along the way). By 1993, MJ’s company was reportedly earning $30m from it (albeit, MJ had added other songs by other artists by that time but let’s ignore this for the moment) and it was estimated to be worth $300m at that time. This yields a cap rate (capitalization rate) of 10, which is pretty typical for this type of privately held asset. No one knows what kind of income stream he gets from this now but it has a rumored value of $1 billion today. MJ still owns 50% of it, the balance is owned by Sony.

 

With a cap rate of 10 and given that MJ owns half of the catalogue, we can guess that MJ gets $50m a year in income from his ownership. Plus the Beatles are making a huge comeback—just ask my 14 year old daughter, Jessica, who only wants Beatles CDs for her birthday and knows just about every word to every tune the Beatles ever recorded. So it wouldn’t surprise me if MJ’s income is going up every year from this source. This is called wealth. However, let’s say that MJ is in need of some quick cash and sells his interest to Sony for $500m. Now MJ would be rich (for a while) from selling his interest in the catalogue but he would no longer be wealthy because he has lost the ability to renew his wealth every year by producing an income stream from control over this particular factor of production.

 

But what’s that you say? He could invest the proceeds in T-Bills, Muni Bonds and GICs (Guaranteed Investment Certificates). Sure he could, but they produce puny 1.7% to 4% rates of return. If MJ paid $100m in taxes, he would be left with $400m, which would give him an income stream of $6.8m to $16m a year with no inflation protection. I mean if MJ were to continue to control the catalogue, he could always increase the price (aka royalty) paid for each tune if inflation takes off and starts to bite into his revenue stream. But even ignoring inflation, why would MJ trade an income stream of $50m a year that makes him wealthy to become a remittance man getting $6.8m to $16m a year? MJ has already turned down offers to sell; presumably he understands the Chris Rock difference between becoming rich and being wealthy.

 

Did you know that most lottery winners blow their entire wad in less than five years? By that point, their spouses have left them, they are alienated from their old friends, they have got a whole new set of ‘friends’ who are only around while the money lasts and they don’t even have their old job to go back to. Many of them have picked up nasty habits along the way like taking drugs. It’s absolutely amazing how many of them end up in bankruptcy. They are much worse off for their ‘good fortune’.

 

People are meant to work. They are built for it. If you have built a good business, hang on to it, fight for it—it is your security against creditor phone calls in the middle of the night asking you: “Mr. Smith, when can we expect payment?”

 

Conclusion

 

We now know (from reading this essay) that, in Canada, your RRSPs are not safe from creditors. If you get into trouble, creditors like CRA can force you to cash in your RRSPs to pay them off.

 

In the US, your IRAs are protected from creditors, properly so in my view*. I mean we have to understand the difference between errors of commission and omission. Most of us make mistakes but these are what are called ‘honest’ mistakes. We mucked things up and have gotten in over our heads and can’t pay our bills. We didn’t do it intentionally. These are errors of omission.

 

(* I realize that there may be unscrupulous people out there benefiting from this type of protection and some of my readers might not like that very much. O.J. Simpson is out there on a golf course looking for the ‘real’ killers of his former wife and her friend and the only reason OJ has the resources to do this is because his IRAs were untouchable by his creditors. A disgraced NYC lawyer I know has a huge house in Tampa (not the real location) because he benefits from the Homestead Act, which in many southeastern and western States allows your principal residence to be exempted from your bankruptcy estate. That is why you see some tremendous homes in some US cities in these States. The original intent of the law was to protect people (mainly farmers) who were petitioned into bankruptcy by the Banks during the Great Depression of the 1930s. They got to keep the ‘home place’ but all their land was lost.)

 

There are people out there who are committing errors of commission. I know one fellow who runs an import/export business (actually it’s in another industry) who keeps bankrupting his companies and stiffing his suppliers. I presume he is somehow pocketing, or his family is, the money he does not pay his suppliers. Sounds like serial fraud to me.

 

However, at least in my view, we should not ‘reform’ bankruptcy laws because there are bad people around. We have other laws for them—it’s called fraud. So my advice to lawmakers is not to harden bankruptcy laws (for example, by taking away IRA protections or the sanctity of the homestead) just because there are some bad characters around.

 

You often find that Governments react in a knee jerk fashion to extreme cases like the above and the public outcry that comes with it. But exceptions like this do not make a good basis for writing new laws. And the unintended effects on honest entrepreneurs who are trying to create new ventures and new opportunities and, at the same time, protect themselves a bit and their families too, will be devastating. Society as a whole will lose new jobs, new wealth and a generation of entrepreneurs is at risk as well.

 

The crooks will always find other ways to hide their wealth anyway; it’s the honest folks who will get slammed to the mat.

 

Copyright. Dr. Bruce M. Firestone, Ottawa, Canada. December 2004

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