I spend a lot of my time representing business owners in disputes with their business partners. As part of that job, I have an opportunity to see the variety of ways in which one business owner tries to rip off another business owner. I want to share with you some of those techniques, not so that you can use them on your business partners so that you have a better chance of spotting and preventing those techniques from being used on you. So we are calling this our Good Guy’s Guide to the Dark Art of Ripping Off Your Business Partners.
What I want to talk about is one of the more advanced techniques that we see being used, and it involves purchasing the debt obligations of a company. We see this used most frequently in real estate entities—entities whose sole purpose is to acquire to develop or redevelop a piece of real estate. That being said, it can really be used with any type of company that has third-party debt—debt owed to a bank.
I’m going to explain this technique using a hypothetical real estate company. The company is owned by two shareholders, or two of members of an LLC, and the LLC or the company’s sole asset is a piece of real estate. The company has borrowed from a bank or a third-party lender to purchase the real estate. Let’s assume that the bank has required each of the partners to offer a personal guarantee securing the loan, and has also taken a mortgage in the real property that the company owns. Let’s assume that the loan is for a million dollars. Let’s also assume that the debt is a troubled debt, that perhaps the company is in default for missing a payment or perhaps the collateral, the real property, has declined in value to such an extent that the bank feels that it is under-secured, that the loan is under-secured and under-collateralized.
So in this technique, the ne’er-do-well shareholder or the ne’er-do-well partner will go to the bank without the other partners’ knowledge. They may go directly, but more likely they’re going to talk to the bank using a representative—sometimes a lawyer, sometimes another business person acting on behalf of a company that the ne’er-do-well shareholder has created for this purpose. The shareholder is then going to offer to purchase the loan from the bank at a discount. For example, if a million dollars is owed on the loan, perhaps the shareholder purchases the loan for $800,000. The bank agrees and, so, the purchaser—the ne’er-do-well shareholder—gets a million-dollar debt for $800,000. It gets the mortgage, and it gets the personal guarantees that go with it. So the ne’er-do-well shareholder has purchased this million-dollar debt for $800,000, and now it has a few things that it can do. One of the things it can do is go and foreclose on the property, can realize money from that. If that money is a shortfall, the shareholder can then pursue the other business owner for the balance on the personal guarantee.
So let’s just fill in some numbers. For example: Let’s assume that there’s a million-dollar debt and the property is worth $600,000. Well, the ne’er-do-well shareholder can foreclose on the property and either generate $600,000 or take possession of the property after a sheriff’s sale, and then the ne’er-do-well shareholder can pursue his or her business partner on the personal guarantee for the remaining $400,000. Ultimately, if the ne’er-do-well shareholder is able to collect, they have realized a million-dollar debt and made $200,000 off the back of their co-shareholder.
Now if you’re tracking this closely, you may ask yourself what exactly has the ne’er-do-well shareholder stolen? They went to a bank, and in an arm’s length transaction, the bank and the ne’er-do-well shareholder agreed to purchase and sell a note for an amount of mone. How has the ne’er-do-well shareholder ripped off his or her partner at all? Well, the reason they ripped off his or her partner is because they’ve usurped or taken an opportunity that should have belonged either to the company or to the partners collectively. What do I mean by that? Well, assuming the bank is willing to part with their loan at a discount, then the company should have been able to go to the bank and say, “We will offer you $800,000 instead of a million to forgive our debt, satisfy the mortgage, and release us from the personal guarantees.” In that instance, the business owners would have shared proportionally in the $200,000 discount that the bank was offering. When the ne’er-do-well shareholder contacted the bank without his or her partners’ knowledge, he or she essentially took the full benefit of that discount that the bank was offering. You may be saying, “Well the bank would have never offered that discount for the company itself.” Maybe so. If that’s the case, then the ne’er-do-well shareholder could have done the same thing in conjunction with his or her business partner. They could have gone out and formed a new company that concealed their identity in some way, and negotiated with the bank that way. In either circumstance, both partners would have enjoyed the discount that the bank was offering.