Out of proportion

On divorce, the ‘sharing principle’ generally applies to all marital assets, meaning that those assets should be shared exactly equally between the divorcing couple. The first step to be undertaken by advisors is to quantify all the assets owned by the couple in their sole or joint names, and held directly or indirectly. The next step is to categorise them as ‘marital’ (for sharing) or ‘non‑marital’ (generally to be retained by the owner).

Assets owned prior to the marriage that remain separate and are not used or relied upon financially by the couple during the marriage retain non‑marital status. Therefore, if one owns shares in their family business at the date of the marriage (received, say, by way of gift or inheritance) and they play no role in the family business at all, the entire value of the shares on divorce is almost certainly not a marital asset. However, if one is a director or has some other active role in the business, especially managerial or in giving direction, then any increase in the value of the business during the marriage is a marital asset. This assessment will be fact‑specific, so if one holds, for example, a non‑executive directorship, then the court will look at the reality of one’s involvement in the business (such as the frequency of meetings attended and decision‑making powers) to determine if the increase in value of the business is a marital asset. Any business that is set up by either party during the marriage is a marital asset from the outset, unless a pre‑nuptial or post‑nuptial agreement provides otherwise.

Depending on which category the business asset falls into, different valuation exercises will be required. If the asset is non‑marital, then no formal valuation will typically be required since it is being retained in its entirety. If the asset has always been marital, then its entire value will be shared, so just a valuation as at the date of the final hearing will be required. If only the increase in the asset’s value during the marriage is marital then, of course, both a valuation as at the date of the final hearing and a valuation as at the date of the marriage will be required. Where no valuation of the business exists from the time of the marriage, this retrospective valuation exercise is the most challenging aspect of the division of business assets on divorce, and the greatest source of dispute and deliberation in case law on the topic.

The case law

In Jones v Jones,[1] the England and Wales Court of Appeal (the Court) had to consider the fair division of assets where the husband had owned his business for ten years prior to the marriage but, due both to favourable market conditions and the husband’s hard work, the business had grown significantly during the couple’s ten‑year marriage. The wife appealed after the court of first instance had awarded her GBP5.4 million out of the couple’s assets, totalling GBP25 million.[2] The first instance judge had attributed 60 per cent of their wealth to the husband’s pre‑marital share in the business and split the remaining 40 per cent equally. Lord Justice Wilson in the Court allowed her appeal and held that:

• The approach of the first instance judge had been arbitrary: the starting point should be that the marital assets are GBP25 million less the value of the business at the time of the marriage. The business was worth GBP2 million at the time of the marriage, providing the starting point of GBP23 million to be shared equally.
• The sum of GBP2 million had to be moderated upwards to take into consideration the concept of ‘latent potential’ in the company at the time of the marriage (valued at GBP2 million).
• Further allowance had to be made for passive economic growth in the company between the date of the marriage and the date of divorce. This could best be represented by the increase in the Financial Times Stock Exchange (FTSE) All Share Oil and Gas Producers Index over the period (116 per cent). Therefore, the value of the company at the date of the marriage was GBP9 million, which left a pot of marital assets worth GBP16 million and the sharing principle so required the wife’s award to be GBP8 million.

Jones was the beginning of a semi‑mathematical approach to the division of family businesses on divorce. However, as can be seen from the above, one might ask how the judges arrived at GBP2 million as a value for the latent potential in the company, and how might the passive growth deduction be applied uniformly across all sorts of different businesses?

Lord Justice Moylan in the Court took a different approach in the more recent case of XW v XH.[3] Before the couple’s marriage, the husband had co‑founded a business that during their seven‑year marriage became a household name used by billions of consumers globally. When the business was sold one year after their separation, the husband’s sale proceeds were GBP490 million.

Moylan LJ found that the first instance judge was entitled to attribute some latent potential value to the company at the time of the marriage and to categorise part of the proceeds of sale of the shares as non‑marital property. To do so, a judge can err from simply applying the expert’s valuation increased by indexation, as a broad evidential assessment will sometimes reveal that there was significant value not reflected in the formal valuation. The Court agreed with the first instance judge that the ultimate success of the company was attributable to ‘a not inconsiderable extent’ to its pre‑marriage ‘foundations’ and that they remained a ‘significant’ factor. Moylan LJ concluded it was fair to treat 60 per cent of the wealth derived from the shares as marital property and 40 per cent as non‑marital. This has since been described as the ‘broad‑brush’ or ‘alchemy’ approach, which has the disadvantage of being even more unpredictable, but is perhaps more realistic in accepting that you cannot be wholly scientific in the valuation exercise.

Ultimately, where a family business is involved, one must be prepared for a dispute over the proportions of the value that are non‑marital and over the valuations themselves. This is because the accountant’s valuation is one factor among many and it cannot be predicted which factor a judge is going to prioritise over another in the judge’s assessment.

How can we best protect against this problem?

Generally speaking, a marital agreement such as a pre‑ or post‑nup will agree that the ‘sharing principle’ will not apply to one’s marital property. Often, a marital agreement will specifically identify certain assets that will remain non‑marital. If one owns shares in a family business on entry into a marriage, it is always better to have a pre‑nup stating that no matter what the value of the shares on divorce, that value is not to be shared.

As is well known, marital agreements are not a binding contract under English and Welsh law, but when done properly, they are, in effect, binding. The UK Supreme Court ruled in Radmacher v Granatino that:

‘The Court should give effect to a nuptial agreement that is entered into freely by each party with the full appreciation of its implications unless in the circumstances prevailing it would not be fair to hold the parties to their agreement.’[4]

So provided the parties fully appreciated what they were signing and that on divorce the outcome of the agreement’s terms would not leave either party in a ‘predicament of real need’, and the court would not interfere with the agreement. Broadly, ‘real need’ is adequate housing and enough income to live off, not necessarily at the marital standard of living. Therefore, it is important to ensure that after ring‑fencing the family business there will be other assets to be shared and sufficient income to meet daily expenses. Provided that is the case, a pre‑nup should successfully protect the business asset from division. Where there are very valuable business interests and it works from a tax perspective, clients may wish to put the business assets in a trust in addition to having a pre‑nup but, in any event, a pre‑nup is essential.