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

Question

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.

Answer 1

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.

Answer 2

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.

Answer 3

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.

Answer 4

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.

Answer 5

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.

Answer 6

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.