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Let's say that I am confident that some investment will grow by 15% per year, and that I have 10K to invest, and I'd like to use leverage to invest 100K.

What stops me from creating an LLC with 10K in equity, have that LLC then borrow money (let's say at 6% interest rate) and make the investment?

If the investment performs as expected, great - I will have 115k - 95.4k = 19.6K and thus almost 100% in profits, after I pay back the debt.

If the investment performs poorly and in fact loses 50% in value, I end up with 50k - 95.4k = -45.4K in debt, after which I file for bankruptcy and in fact lose just the 10K equity initially invested, thereby substantially limiting the risk.

To clarify, I am not suggesting fraud in any way. Rather, I would like to improve my understanding of the system, because, obviously, if the above were possible, everyone would do it. In fact, I would appreciate answers that explain where the above scenario becomes illegal.

Edits:

  • Delaware LLC fees will amount to around $350 per year, link. Other costs can also apply, but all become increasingly insignificant compared to total revenues if the initial capital is increased

  • A leverage ratio of 4-5 is reasonable; this is based on typical mortgage down payments. However, even a leverage ratio of 1 results in profit increase from 15 to 24%, while limiting risks.

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    Borrow from who at 6%? That part of your plan is underspecified. If you think this is a good deal for the lender then would you personally lend out $10K at 6% to a stranger who approached you with this scheme? Your question is "what is stopping this scheme from succeeding?" Well, if you're unwilling to lend the money to someone who has this scheme then you know the answer; what is your answer? (If you are willing to lend 10K to a stranger at 6% to put this scheme into effect then boy have I got a deal for you. Send me the $10K and I'm going to Vegas. :-) ) – Eric Lippert Jun 13 '18 at 20:55
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    I feel like there's a morality issue in here somewhere too... – TTT Jun 13 '18 at 21:19
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    @EricLippert It's even worse ... the OP's wanting someone to lend $100k (not $10k) on the basis of "I am confident..."! – TripeHound Jun 14 '18 at 9:05
  • Delaware LLCs are too expensive and Delaware's laws favor corporations, not LLCs. Go with Wyoming or Nevada, fees are ~$100/yr, and even that's high because they know they gotcha. As little as $20 in other states, but they'll disclose your Member list. Also you'll need a Registered Agent in that state, $150-200/yr. – Harper - Reinstate Monica Jun 14 '18 at 15:46
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    @TTT agreed, and I would like to see that mechanisms, including legislation and oversight, are in place to prevent this. – Zubo Jun 14 '18 at 18:14
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Answer: Due diligence by the lender.

It occasionally happens, and sometimes the lending officer is in on a scam, but banks do not tend to loan money where there is a large chance that they will not be paid back.

It's been my experience that an LLC that borrows money will have to have some assets, or have the assets of the owner stand for the money that the LLC borrows.

Your model requires leverage and profit to work. However, no bank is going to extend you that kind of leverage with that kind of business plan. The only element that the LLC adds is higher costs. Can you borrow money to invest in stocks? Sure it is called a margin account.

Heck there are probably commercial banking laws that prevent what you are suggesting. You are skirting margin requirement laws that came about from the stock market crash in 1929. People were doing exactly what your are describing. Borrowing at 10:1 to buy stocks, and then losing it all.

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    @Zubo That's the same as just borrowing the money personally, ultimately. – Grade 'Eh' Bacon Jun 13 '18 at 14:56
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    Perhaps. There is a cost to running an LLC, and you would have to preserve the 10k so the bank can take it if you do not pay back the loan. So your profit in this very mythical scenario would be less using an LLC. If you are intent losing money this way, buy a car and then get a loan on it. Use the proceeds to speculate. – Pete B. Jun 13 '18 at 14:59
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    @Zubo Any risk you think you've removed by placing it in an LLC, is risk that the bank would have to take on. The bank isn't a fool, and they will refuse to take this risk. In general, corporate lending for small businesses requires personal guarantees, just to nip all this in the bud. To the extent the lend you based on securing the company's assets, they will be careful to do so in a way that they never get burned [like a broker which gives you a margin account but calls in all your stock immediately when your portfolio reaches a particular net value]. – Grade 'Eh' Bacon Jun 13 '18 at 16:35
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    @SolutionMill Only if that small group is called the "We Want To Lose Our Money Clan". – TripeHound Jun 14 '18 at 9:08
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    I've been partners in five LLCs. (all in America). The bank won't lend you money on the cash in the company; they know very well that can disappear tomorrow and thus is an unsecured loan. The owner of an LLC can distribute cash to himself at any time. The bank only lends money on secured assets with firm or appraised value; like a building, or insured equipment like trucks or bulldozers. Which you then cannot sell without breaking the law. Banks loan on personal assets; typically homes. Yes, you can get an LLC for $400 or so, but it doesn't come with a credit line! – Amadeus-Reinstate-Monica Jun 14 '18 at 21:27
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Alright, so the bank would still, then, agree to lend 10K against the 10K in equity, right? That still significantly increases profits (24% vs 15%) and would afford the same loophole.

As a general rule, no. The bank will loan the LLC money if the LLC has a proven income record. Banks will generally not loan money secured by stocks for this exact reason. In the US, that's likely to be covered legally. Consumer banks are legally prevented from loaning with stocks as collateral.

An investment bank could do this, but absent chicanery, they won't. This is a turkey of a loan. A brand new LLC with no income history and no business plan. Its only assets are 10k in stocks. Perhaps they might loan 5k on the 10k in stocks at 18% interest (like a credit card). So your upside would be 4.5% (lower than the original 15%) minus the LLC fees. And your downside is a 100% loss of 10k plus any LLC fees (bankruptcy).

6% on a line of credit is the kind of thing that banks offer long term customers or people with separate income. I.e. if you are making 100k a year and launching a side business, banks will give you 6% interest on the side business knowing they can collect from your regular job.

Also be aware that it is possible to pierce the corporate veil. This is generally an option when someone creates a corporate form (e.g. an LLC) for the sole purpose of shielding from legal liability. So it is possible that your LLC's debts could be shifted onto you.

There are ways to make something like this work. Most of them involve having an established (not new) LLC owning real property (i.e. real estate). This is essentially the house flipper model. The problem is that you really need cash to make cash. Borrowing will eat up most of your profit.

The proper use of loans here is as short term bridges. For example, you have an opportunity to buy a new property, but all your cash is tied up with a property that is currently in escrow. You take out a short term loan against the property in escrow so as to make the purchase. As soon as the sale closes, you pay off the loan. The property that you purchase may offer enough of a discount to justify the interest charges. But most of the time, you would be better off waiting for a different deal.

A leverage ratio of 4-5 is reasonable; this is based on typical mortgage down payments. However, even a leverage ratio of 1 results in profit increase from 15 to 24%, while limiting risks.

Sure, but that's on a house. You are buying a 100k house with a 20k downpayment. So if the house loses 20% of its value, they still get 80k on an 80k loan. And again, a brand new LLC is unlikely to be able to get even a mortgage on its own. You would probably have to cosign the loan personally.

Houses are less likely to lose value than stocks. And if they do lose value, they tend to lose less value. Extrapolating from houses to stocks is unreliable. They're different kinds of investments.

If you really want, try it. You'll be out the LLC fees, but that's survivable. The most likely result is that you'll talk to a bunch of banks that will say no. A waste of your time, but again survivable.

  • Thank you for the detailed answer; also really appreciate your excellent English. I gather from it that the short answer would be "you won't get a loan"; thanks for taking the time! – Zubo Jun 13 '18 at 15:56
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    Discussion of piercing the corporate veil is particularly appropriate here; in an example case where the OP attempts this plan, loses money, and the bank goes out for him, this post itself would be evidence that the purpose of the LLC was to defraud the bank. – Grade 'Eh' Bacon Jun 13 '18 at 16:38
  • What about the scammy-sounding "preapproved, unsecured business loan" offers? I'm guessing they just have interest rates and fees so high that they don't care? – R.. Jun 14 '18 at 3:11
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    Or they will insist on a personal cosign. "Oh, it's just a formality. After all, you plan on paying us back, right?" – Brythan Jun 14 '18 at 3:40
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Where your scheme fails is the bankruptcy. It wouldn't work.

You'd be personally liable: the shield wouldn't hold

You get the loan. When you default on the payments, and certainly the moment they are served notice of your bankruptcy filing, the lender will go "Hold on there!" And use discovery to uncover the LLC's activities and the nature of your business.

The lender will argue "Your LLC was not adequately capitalized" for the eminently foreseeable business risks: specifically risking $100k in the stock market. There's a fundamental rule that you must put enough money into a shielded entity for it to stand on its own as a functioning business, and not just go insolvent at the first minor misfortune.

Due to lack of adequate capitalization, they would ask the judge to pierce the corporate veil and cause the LLC members (jointly) to be made personally liable for that debt of the organization. As well as collection activities and court costs.

So you've already lost the veil. And now this happens:

If the bank's paperwork for the loan showed at the time you borrowed you were not 100% forthright about your intentions, i.e. fraud:

  • it would prejudice the "pierce the corporate veil" argument, meaning that if the judge wasn't sure before, she's sure now.
  • Claiming fraud allows them to argue for triple damages.
  • Fraud would let them object to your personal bankruptcy: You'd owe the $100k (x3) for life.

Wow, that makes it a pretty good deal for the bank. Lend $100K, get back $300K+interest, personal liability, non-dischargeable. Don't get to write loans like that every day. All they gotta do is structure their paperwork so they can claim they didn't know your intent.

  • Right. You'd pretty much have to lie on the loan application where you state what the money will be used for. – TTT Jun 13 '18 at 21:17
  • Yes, by having put the question out on this site, that would be discovered in a suit. Thus, all the problems noted. – eSurfsnake Jun 17 '18 at 5:34
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I think you simply need to understand credit risk. A newly formed Corporation with zero operational history and a $10,000 bank account is, from a default risk perspective, a suicidal toddler with $10,000.

The simple fact that you own 100% of the stock of the corporation doesn't mean your assets and credit history get to be a factor in a corporation's loan underwriting, you would have to personally guarantee the loan. If you personally guarantee the loan you haven't shifted the risk.

Just think about it. If all it took was a $350 fee, why would any person hold any personal debt? I'd pay my $350, and have all debt issued to my corporation. If things go sideways, I'll just form a new corporation and start over because there's no downside to me.

7

Why cannot LLCs be used to negate increased risks when doing leveraged investments?

If the investment performs poorly and in fact loses 50% in value, I end up with 50 - 95.4 = -45.4K in debt, after which I file for bankruptcy and in fact lose just the 10K equity initially invested, thereby substantially limiting the risk.

You really answer your own question; lenders are not in the business of losing money, and so minimize the chances and impact of possible losses.

Your plan limits your risk while massively increasing their risk.

  • Agreed, but banks routinely provide mortgages with a leverage ratio of 4-5. – Zubo Jun 13 '18 at 15:39
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    Mortgages are secured by the house. If you fail to pay the mortgage, they take the house. OP is talking about a loan secured by absolutely nothing. – Magua Jun 13 '18 at 15:53
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    @Magua Or rather, secured by stock, which is vastly less stable than housing. (+1) – Charles Jun 13 '18 at 18:26
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What you want is called margin trading. Leverage can go as high as 1:100 depending on the traded product. But you will be required to maintain appropriate equity for margin requirements. If you don't then your positions will be closed for you, so generally you won't be allowed to lose more than you have.

Just giving you money? Not going to happen.

Giving you money under appropriate terms and condition? Yes, that's possible. Margin trading is investment product, but the risks are amplified more than the profits.

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