It is very common for people to transfer assets to a spouse (or family trust) before embarking on a ‘risky’ activity. For example, before going into business, becoming a partner in a professional services firm, or undertaking a development. But is this really effective?
On its face, the recent Federal Court decision of Wallace v Wallace  FCCA 963 (31 May 2016) (Wallace’s Case) suggests that transferring an asset is unlikely to be an effective strategy.
But as usual, there’s more to it.
In this article we discuss what happened in Wallace’s Case, and what you can do to legitimately protect your home.
Let’s start with a couple of philosophical viewpoints.
At one extreme, you have people who go into business, rack up tremendous debts, tank their company, and then start again the next day, with little exposure to their ‘personal’ wealth. They use ‘legal structures’ and ‘asset transfers’ to avoid taking responsibility for their actions: effectively transferring a large portion of the risk to a lot of small creditors (and usually the ATO, i.e. us taxpayers).
This first view is often the lay-person’s naive view of how the law actually works, and is sometimes promoted by unscrupulous politicians wishing to grab a headline.
At the other end, you have people who have transferred assets to a spouse or trust well before going into business or incurring any liabilities, who have properly structured and capitalised their enterprise, and have just been unlucky. People should be able to choose how much they risk when they go into business or undertake a speculative investment. The effectiveness of our capitalist system, and its encouragement of beneficial risk taking, is dependent on this.
This second view has generally formed the rationale for the drafting of our legislation, including the Corporations Act and the Bankruptcy Act. It is a less sexy story, but it has the benefit of creating a foundation for our modern economy.
Our view is more along the lines of the second viewpoint. You should be able to choose how much you put at risk. Furthermore, creditors must take some responsibility for ensuring they get paid (i.e. contractually and through the PPSR), rather than relying on blanket laws that personally expose business people to unlimited liability.
Our view is that our bankruptcy laws, on their face, adequately balance these two view points. If people seek to transfer assets to avoid an actual or impending liability, then the transfer should be voidable. But if the transfer takes place well before any actual or impending liability, the asset should be safe.
This balanced view was referred to by Sackville J in Prentice v Cummins (2002) 124 FCR 67, where he states at :
“I am prepared to assume for the purposes of this case, without deciding, that if all that is known is that a professional person:
- transfers the bulk of his or her assets to a family member for no consideration;
- has no creditors at the time of the transfer (or retains assets sufficient to meet all liabilities known at that time);
- is not engaged and does not propose to engage in any hazardous financial ventures; and
- intends to protect the transferred assets from any action brought by a client who might in the future sue for professional negligence (there being no such suit in the offing at the time of the transfer),
then s121(1) of the Bankruptcy Act does not render the transfer void against the person’s trustee in bankruptcy.“
Unfortunately, the Courts do not seem to always appreciate practical realities. Wallace’s Case appears to be one of those.
So what happened in Wallace’s Case?
An accountant went into a family business involving motor vehicle retailing. Around the time he became a director (2004), he transferred his interest in his family home to his wife. At around the same time he took on a number of personal liabilities, including responsibility for a financing arrangement with St George. Ten years later the business failed, and the bankruptcy trustee sought to claw back his interest in the family home. St George was one of the creditors.
The Court held that the transfer was voidable under section 121 of the Bankruptcy Act. What is unfortunate is that the Court was less than careful in its reasoning when applying this section.
Most importantly, section 121(4) requires that “it can reasonably be inferred from all the circumstances that, at the time of the transfer, the transferor was, or was about to become, insolvent.“
In our view, section 121(4) requires the transfer and the insolvency to be closely tied together in a timing sense. However, the Court in Wallace’s Case clearly dismisses this. We cannot see any legislative basis for this approach by the Court – and such an approach clearly undercuts the balanced operation of the provisions.
The Court instead relied on a ‘hazardous financial venture’ test – which is clearly not part of section 121. The Court decided that ‘motor vehicle retailing’ was such a hazardous financial venture that it justified accepting a 10 year gap between the transfer and ultimate insolvency.
Effectively, the Court said that because Wallace was embarking on motor vehicle retailing, which is a very hazardous industry, it could be expected that some time in the future things may turn bad. Therefore, any transfer at the outset must be to defeat future creditors – even if those creditors are not currently on the horizon.
Motor vehicle retailing is hardly a very hazardous venture, and certainly no more hazardous than many other industries, (and arguably a lot less hazardous). On this basis, almost any business venture would seem to qualify as sufficiently ‘hazardous’.
We do not think the Court needed to go this far to reach the same conclusion on the operation of section 121. Our view is that the voiding of the transfer could probably be justified on the following grounds:
- Wallace was already heavily committed to the obligations of the business by the time of the transfer, i.e. he was exposed to potential personal liabilities before the transfer;
- The guarantee to St George was entered into around the time of the transfer;
- Although the liabilities did not arise for another 10 years, there was clearly a nexus between the transfer and the taking on of the personal liabilities (both back around 2004); and
- Most importantly, Wallace continued to represent to his creditors (including St George), that he held an interest in the family home (i.e. on applications and personal financial summaries).
Protecting the family home
So what can you do to protect your home (or other asset)?
To start with, some obvious (yet often overlooked) basics:
Adopt a business structure that affords you a good level of limited liability. Most obviously, a company structure. Importantly, you should then operate the company effectively (with proper policies and procedures in place) to ensure you do not fall foul of the various laws that can make you personally liable as a director.
Limit the number of people who become a director, ideally to just one person. There is no reason to unnecessarily expose more people to potential personal liability. Many people appoint their spouse as a director ‘to involve them in the enterprise’. This is folly.
Carefully read the terms of all documentation you enter into, e.g. the terms of any loans, mortgages, leases and supply agreements, that may seek to make you personally liable. Then negotiate.
Be very reluctant to agree to personal guarantees, and keep a register of those you do agree to. Avoiding personal guarantees will be difficult with professional creditors, like banks. However, you do have choice among suppliers.
But if a liability does arise…
You must accept that moving an asset after a liability is on the horizon will not be effective. The Wallace Case would suggest that simply starting a business is enough to create relevant contingent liabilities. Therefore, you should divest yourself of the asset as soon as possible, and well before taking on any actual or contingent liabilities. As noted in Wallace’s Case at 167 “… He was on any view very heavily personally committed to the business by the time the transfer took place.“
Ideally, never own the asset. For example, if you are going into a genuinely risky venture or business, then selling your current home and buying a new one solely in your spouse’s name or in a trust may be a good long-term financial decision. The relevant sections of the Bankruptcy Act require a ‘transfer‘ to have taken place. Time for an upgrade?
Be careful not to make any obvious direct financial contributions to the asset. For example, avoid making any direct contributions to the initial equity or ongoing mortgage repayments. Have these come directly from your spouse’s account or the bank account of the trust. You should meet recurrent and wasting expenses, such as household expenses, rather than contributions acquiring or preserving the asset.
Do not use ‘journal entries’ to record contributions and transfers. Ensure that your spouse or trust makes actual contributions. If using a trust, ensure that the trust has its own bank account and keeps financial records.
Make any asset transfers for full market value. It may be that this takes the form of a corresponding debt obligation (i.e. $1m of debt to acquire an asset worth $1m), but this should cap the amount that may be clawed-back to the face value of the debt ($1m) rather than the increased asset value in 10+ years time.
Importantly, you should never represent to an actual or potential creditor that you have any interest in the asset. In fact, you should explicitly state to creditors that you do not hold any interest in, nor make contributions to, such assets. In our view, this was a critical factor for the Court in Wallace’s Case (or at least should have been!)
If you earn income through a trust, then consider distributing the bulk of any residual income to your spouse holding the asset, so that your spouse has the financial resources to sustain the asset without your direct or indirect assistance.
Follow the terms of whatever documentation you put in place. For example, related-party loan agreements, mortgages, leases, etc. If the terms are not followed, then the Court is likely to ignore the legal significance of the documentation.
If possible, have a good reason for the transfer other than asset protection. This can be difficult, and in our view, should not be necessary. It should be reasonable for someone to say, “I’m not prepared to risk this asset, and I’m taking precautions to put it out of harm’s way.” But the Court in Wallace’s Case thought otherwise.
To get a clear understanding of your personal exposure, or to better structure your affairs, call us on 1300 654 590.