The family shareholder
All business owners have families and family concerns, but not all owners bring their family members into share ownership with them.
All business owners have families and family concerns, but not all owners bring their family members into share ownership with them. This can add real value and strength to the business given the ties of loyalty and understanding that family members can add to the management and ownership group. It also, of course, comes with the risk that family discord or marital breakdown can have a potentially direct damaging effect on the business, making decision making and the passing of ownership more difficult than might otherwise have been the case.
In this latest article in our series aimed at the issues and concerns impacting owner-managed and family businesses, we consider some of the issues that need to be addressed when sharing business ownership with family members.
Family transfers of shares
Should transfers of shareholdings to family members or family trusts be permitted? Of course, this is a matter for individual choice, and owners need to balance the perceived benefits against risks of disputes between co-shareholding family members and complications arising on relationship breakdown, particularly so on divorce. No owner is compelled to transfer shares to a family member and so, if and when doing, there is no reason why, for example, the transfer cannot come with strings attached such as to prohibit the shares being transferred on again to any party without the owner’s consent, so helping to ensure that shares stay in family ownership.
Shareholders agreements and articles of association
In our previous article on sharing ownership, we examined in general terms the issues to be considered in any shareholders' agreement. In the specific context of a company with family shareholders, an owner when bringing family into co-ownership should consider ways in which, should he or she wish to, they can project again the risks of future family breakdown.
This may be in part achieved by contractual provision in a shareholders agreement or articles of association which for example could provide that:
- Shares may not be transferred without the board’s consent.
- If shares are to be transferred they must be offered back to the owner.
- That the owner is not compelled to buy them back and if he or she choses not to, the family shareholder may simply have to remain in the company as shareholder i.e. they cannot compel a sale
- That the valuation to be adopted should the shares have to be sold back to the owner reflected (if it was the case) that the shares only represented a minority interest and so suffered a valuation discount.
Remember a corporate vehicle is a separate legal identity to that of its owner and as such, on divorce, the family court will in general terms need to respect the express terms of the articles/shareholders agreements. Whilst there have been occasions when the court has been creative in finding solutions to the problems posed by the corporate governance documents, the court does have limited powers to intervene.
The underlying economic value of a share must be fully taken into account In England and Wales when assessing the family wealth to be apportioned on divorce (in Scotland it will only be taken into account if acquired during the marriage), but the courts will not in normal circumstances compel the transfer of legal ownership against the provisions of shareholders agreement or articles where there are other co shareholders who have rights in those agreements to object to such a transfer. Different considerations would apply where a company was in the sole ownership of someone going through divorce, where the court (certainly in England and Wales) could compel a legal transfer. (In Scotland, they might be asked to pay a capital sum in lieu of a share of the value which could cause significant financial pressure.)
Similarly and since the provisions of shareholders agreements and articles are to be respected, provisions that legitimately suppress value such as requiring minority shares to be valued at a discount will be taken into account by the court when assessing the value to be attributed to a shareholding. Bad leaver provisions can also affect the notional value of the shares.
Pre and post nuptial agreements
Those considering marriage should always give thought to entering into a pre nuptial agreement, and this is particularly so where one party has built up a successful business or is considering transferring part ownership to his or her sons or daughters but may be concerned about what impact a future marital breakdown might have and want to try and preserve share ownership to direct (and continuing) family members. In such circumstances, it makes sense for the prospective spouse to try and ring-fence/preserve the capital they have accumulated prior to the marriage, in the event of a future divorce. Alternatively, they may simply wish to ‘pre-determine’ the scope of a financial settlement on divorce, and try and avoid the stress and cost of contested litigation on the issue later down the line.
New found wealth can also arise during the course of a marriage, perhaps as a result of a management buy out or sale of the business. Wealth protection strategies invoked should include consideration of a pre or post nuptial agreement, whether for the recipient of the wealth or for future generations of their family if lifetime estate planning is being undertaken.
Similarly, in the event of a business restructure, and if consideration is being given to allocating shareholdings to extended family members, pre and post nuptial agreements can be a useful tool to regulate how those shareholdings should be dealt with, should there be a future divorce, in order to best protect the business moving forwards.
Are pre and post-nuptials agreements legally enforceable?
A pre-nuptial agreement or post-nuptial agreement can be helpful in limiting claims against a business. In Scotland these agreements have been valid for centuries. In England and Wales, although not yet legally binding, since the Supreme Court judgment in the case of Radmacher v Granatino in 2010, the law has been developed in the courts such as to provide significant protection to those seeking to protect their assets in either a pre or post nuptial agreement.
Although the courts are not obliged in England and Wales to give effect to the agreement and parties cannot oust the jurisdiction of the court, the court must give a pre or post nuptial agreement appropriate weight when exercising its discretion, should there be a divorce. This is subject to certain safeguards being put in place when entering into the agreement.
If safeguards are adhered to, the usual advice given to parties is that they can – and should - expect to be held to the terms of any pre or post nuptial agreement entered in to on a future divorce. In Scotland, the situation is more marked. The agreements will be upheld by the courts unless they were not fair and reasonable at the time they were entered into. They can effectively therefore oust the jurisdiction of the court.
Similarly, any unmarried couples living together should also consider the legal implications which flow from such a commitment. Again, there are differences in the way cohabitants are treated in Scotland compared to England and Wales because of the different legal systems.
Despite common belief, there is no such thing a ’common law spouse’ and cohabitees can be left very vulnerable in the event that a relationship breaks down. In England and Wales - unlike married spouses or civil partners - cohabitees cannot claim maintenance for themselves or a share of their partner’s capital assets or pension. This is regardless of the length of their relationship or whether the couple have children. Any property claims they may have will be limited to any interest they are able to establish under land or trust laws. This can be complex, stressful and extremely costly.
In Scotland, there are specific rights to a cohabitant to a share of joint belongings, joint savings and to a capital sum to balance out any economic advantages and disadvantages suffered during the relationship. There are also provisions for extra payments in respect of the care of children and on death. The law is complex though and there are strict timescales to make such claims in Scotland, so advice should be sought at the earliest possible stage on separation or death.
It is, however, possible in both jurisdictions to enter into a cohabitation agreement which can set out in black and white how any assets should be divided in the event that the relationship breaks down. It can also deal with how a party wishes to provide for any children of the relationship and deal with any joint purchases.
Provided both parties freely enter into a cohabitation agreement, it is drafted carefully with safeguarding criteria adhered to, and both parties provide financial disclosure and receive independent legal advice, there is no reason why such an agreement should not be legally binding.
Trusts from a family law perspective
Should company shares be held in a trust structure? Again, the competing tax and estate planning issues must be balanced against the protection a trust provides in the event of a relationship dispute.
On a divorce, the court looks to reach a fair solution for a financial settlement. It does so with reference to the resources of the parties, from all sources and worldwide.
In England and Wales, there is a duty within divorce proceedings to disclose any interest in a trust. How it comes into play in the settlement will depend to a large extent on:
- The nature of the trust – whether it can be said to have a ‘nuptial element’;
- The powers afforded to the trustees;
- The extent to which the trustees have exercised their discretion in favour of the beneficiary prior to a divorce.
In some circumstances, Trustees can be joined into divorce proceedings and asked to explain distributions or produce documents.
If a trust can be said to have a ‘nuptial element’, i.e. a settlement made during the course of or in contemplation of a marriage, which benefits one or other spouse, it is likely to be viewed by the court as a nuptial agreement and capable of variation by the family court in England and Wales.
Even if a trust is not nuptial as such, and so cannot be varied, it is still a resource of the beneficiary to which the court will have reference. In England and Wales, a court will be quick to infer it as a source of funds if there is a pattern of the trustees having paid out income or capital to a party (and so consider at the outset whether the trust should make distributions and the implications if they do) and in some cases, even if there is no track record of payments, courts have been known to give judicial ‘encouragement’ to the trustees to exercise their discretion in favour of a spouse, to reflect the potential resource available to them, and for example, raise funds to pay the other spouse a settlement.
If there is a wide class of beneficiaries other than a married member of the family and their spouse for example, this can sometimes support an argument that it is not nuptial / linked to a marriage.
In Scotland, trust assets are generally excluded from the definition of matrimonial property so are usually left out. It can be therefore invaluable to have family assets tied up in a trust where there might be the possibility of divorce in the family amongst beneficiaries.
In some cases, consideration could be given to exclude provision for spouses and provide for provision to pass straight to the next and future generations instead.
What must always be born in mind when placing shares in a trust is that the settlor will lose control of the shareholding and place control in the hands of trustees. This can directly impact on the settlor’s level of influence and control in the business going forward.
All concerned must not only provide the information that is required to comply with the obligation to provide full and frank disclosure of financial resources, including business accounts (which can include management accounts) but exploration of key issues should be undertaken which will enable those concerned to understand how to protect the business and its assets and mitigate the risks posed by a divorce.
Is the business intended as an ongoing income stream for the family? What was the purpose and strategy of the business prior to divorce – was it intended to be sold within a certain timescale or passed to future generations?
Some are tempted to take pre-emptive steps to alter shareholdings or move assets. It is extremely important not to take any steps without having discussed them with an expert family lawyer in advance. The court has power to set aside transactions intended to defeat the other spouse’s financial claims and untold damage to that party’s case, and their credibility before the court, can be done.
Impact of a clean break
Many divorcing business owners would prefer to achieve a clean break settlement where both parties have no further financial claims against the other in the future. Despite the obvious attraction of a clean break, will this result in a ‘fair’ outcome between the spouses, and how is risk managed? There can be risks on all sides. An undervaluation of a shareholding may result in the spouse who has relinquished a share of the business feeling aggrieved when the business is subsequently sold for a greater amount than the valuation placed upon it at the time of the divorce. On the other hand, the fortunes of the business may falter, leaving the party exiting the relationship with the more ‘copper bottomed’ assets in a much stronger position.
Case law suggests that it is very unlikely that a future change in fortune, either way, is sufficient to justify the setting aside of the original order. As such, detailed consideration must be given to all options so that the benefits and risks can be fully analysed.
Issues arising when family members share corporate ownership are not all of course about what happens in the event of e.g. divorce. Family issues have the potential to spill over into the affairs of a business particularly where there are inter generational issues and a widening family group.
A family charter or family constitution is an increasingly popular management and succession planning tool for family businesses. A family charter can be as wide ranging or simple as a family may require but should contain a statement of intent/agreement to which all the family members subscribe.
It typically covers all those issues which are not capable of being included in the company's articles of association (or shareholders' agreements) or which are difficult to construe as legally binding obligations.
The document itself is drafted in the style of an informal statement which is expressed not to be legally binding. However, in practice there are sections of the document which are supplemented by supporting governance documents and structures which are legally binding documents. For example:
- Shareholders' agreements
- Pre and post nuptial agreements
- Cross option agreements and life insurance policies
- Lasting powers of attorney.
A family charter often includes information such as:
- Ethical guidelines to be followed by the business, including the company's policy relating to corporate social responsibility;
- How the family wishes the business to be run including their goals and long-term strategy for the business;
- Educating, involving and providing careers for the next generation of family members;
- The family's relationship with the business; and
- How the family members should behave towards each other in the context of the business.
The parties to the charter may include family members who are not necessarily shareholders. For example, they may be beneficiaries of a family trust which owns shares in the company. This is one of the features which distinguish family charters from shareholders' agreements.
Family charters are used to address common problems in family businesses such as:
- The impact of taxation on the death of a shareholder;
- Tension between family generations where younger generations drive a business forward but ownership remains with the older generations;
- The financial impact of buying out a deceased shareholder’s shares;
- The impact of a shareholder’s divorce on the running of a family business;
- The death of a director/shareholder who drives the business forward.
It’s said that all happy families resemble each other, but each unhappy family is unhappy in its own way; hopefully with our guidance we can help make family share ownership harmonious and beneficial for all involved.