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Ancillary Relief and the Credit Crunch (Part 1)

Alexander Chandler, of 1 King's Bench Walk, examines the impact that the current market volatility and economic environment could have on ancillary relief proceedings. The article is in two parts. Part 2 will be published on 10 November.

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Alexander Chandler, 1 King's Bench Walk

"This is worse than a divorce. I've lost half my net worth and I'm still married."
(Unidentified trader)

In one year, property prices have fallen 9.2% nationwide1  and the number of sales has dropped almost four-fold2, forcing many sellers to slash asking prices in the hope of achieving a sale. In September and October 2008, the crunch became a crisis, leaving the economy on the brink of recession with unemployment predicted to rise to 2 million by Christmas, half of small businesses reporting a major downturn3 and one in ten mortgage holders, 1.2 million home-owners, believed to be already in negative equity4.

The full force of these developments is yet to be felt, but they herald a tide change in ancillary relief. 

Fairness and risk
Over the past decade, the courts have wrestled with how wealth built up during a marriage, the 'financial fruits of the matrimonial partnership' or 'acquest', should be fairly shared. A number of the leading cases have concerned spectacular wealth (e.g. Miller, Sorrell, Charman5 ) as well as how massive surpluses of income or annual bonuses should be divided (Parlour, McFarlane, H v H6).

The courts have only rarely had to deal with the opposite scenario, a decline of assets during a marriage. In NA v MA [2006] EWHC 2900 (Fam); [2007] 1 FLR 1760, shortly after marrying, H inherited £60 million. By the time of final hearing, after a relationship lasting twelve years, and due to losses sustained in a number of business ventures, this fortune had reduced to £40 million. Overturning a post-nuptial settlement, Baron J awarded W £9.17 million on basis of housing need with capitalised maintenance. Unsurprisingly, in a case involving substantial assets and two minor children aged 6 and 4, needs were the determining factor.

Recession brings other principles to the foreground, most notably that, first consideration having been given to the welfare of any minor children, there should be a fair sharing of the 'risk-laden' and the more secure 'copper-bottomed' assets. In Wells v Wells [2002] EWCA Civ 476; [2002] 2 FLR 97, the capital assets were worth £1.84m, in addition to H's shareholding in a Soundtracs Ltd, which was a company in a 'precarious' state. At first instance, W achieved £1.33m, representing around 72% of the net capital. The Court of Appeal accepted H's criticism that the court had 'effectively provided first for the wife, leaving the balance for the husband':

"…we were at once struck by the security of the result that the wife had achieved in contrast to the risks confronting the husband's economy… Had the marriage survived the family would undoubtedly have shared adversity as it had shared prosperity. The years of marriage comprise the years of the husband's commercial vitality between his late 30s and his mid-50s…But the future years look hazardous… . In principle it seems to us that the separation of the family does not terminate the sharing of the results of the company's performance. That is easily achieved in any case in which the wife's dependency is met by continuing periodical payments. It is less easy to achieve in a clean-break case. In that situation, however, sharing is achieved by a fair division of both the copper-bottomed assets and the illiquid and risk-laden assets…" Thorpe LJ, para 24.

This sharing of risk could be 'easily achieved' with ongoing periodical payments, although in Wells the Court respected both parties' wish for a clean break. It could also be achieved by the transfer of part of H's shareholding to W:

"…an increase in her share of the illiquid and risk-laden asset would have allowed a reduction in the Duxbury fund, if not in the housing fund. If profitability were not recovered then both parties would share the experience of a marked reduction in standards of living" (para. 24)

However, the Court noted this would have incurred a substantial tax liability, and accepted W's counsel's submission that; "…whilst it might have been an option for the judge it is plainly not an option for this court in present circumstances" (para. 25). Ultimately, the Court decided to reduce W's share by £190,000 – noting that whilst the company might trade out of its difficulties, "The extent of that chance was not quantified and was probably incapable of quantification" (para. 29).

Schedules of assets and volatility
It is trite law that assets should be valued at the date of trial, and particularly important in a recession, that the court should have the most up-to-date evidence:

"The assessment of assets must be at the date of trial or appeal. The language of the statute requires that. Exceptions to that rule are rare and probably confined to cases where one party has deliberately or recklessly wasted assets in anticipation of trial." Thorpe LJ, Cowan v Cowan [2001] EWCA Civ 679; [2001] 2 FLR 192, para. 70

However, at a time of highly volatile markets, this presents a problem. Anyone holding shares or equity-based investments and pensions will have experienced a roller-coaster ride as the FTSE 100 dropped 36% in six months7 only to rise 8% in a single day8. Whilst some popular shares are bucking the trend, e.g. BP recently rose 20% in three days9, the value of other previously stable sectors such as commercial and investment banking has collapsed: HBOS shares dropped 72% in five weeks10, Morgan Stanley fell 60% in a five day period11 and Goldman Sachs shares fell 27% in two days only to recover 38% the following three.12 

A schedule of assets, necessarily a snapshot of the parties' finances taken a few days before the final hearing, will generally give no indication of the stability or volatility of values. Nor will it emphasise the difference in liquidity between immediately realisable assets such as shares and policies and real property which in a buoyant market could be realised within a few months but which might fail to attract any interest in a stagnant market. In a recession, an asset which can be realised may have greater value than one that cannot.

The financial position of a party who works in banking or who held a substantial share portfolio or a number of equity-based investments, would have changed dramatically depending on whether a schedule was prepared in August, September or October of this year. For clients who hold property overseas, the volatility may have been further exacerbated by the drop in the value of sterling against the dollar from $2:£1 to $1.60:£1 and its weakening against the euro.

Uncertainty over the value of real property can be resolved simply, by dividing the net proceeds in percentage terms, whereby the risks and gains are fairly spread. However, in the present climate, it may be doubted if a settlement that leaves one party with a fixed lump sum and the other spouse with the volatile equity-based assets achieves fairness. 

Ideally, applying Wells, there should be a fair sharing of the different types of capital assets to reflect the spectrum of risk between money in the bank (insofar as bank deposits are still safe), the net equity in a property, investments, shareholdings in public and private companies and pensions.

The problem with this approach however is tax, namely that assets transferred after the fiscal year of separation will attract a capital gain liability calculated at 18% of the gain13. By contrast, where the parties have lived together at some point during the fiscal year (i.e. 6th April to 5th April the following year), transfers between a husband and wife or civil partners are made on a no gain/ no loss basis14  and will not be taxable15 . The litmus test is permanent separation rather than physically vacating the property.16

"There is no requirement that they should be living together throughout that year. If the couple are living together at some time in a year of assessment assets can be transferred between them at any time in that year of assessment at no gain/no loss."
Taxation of Capital Gains Act 1992 s 58(1)

The tax impact of any proposed division of assets must always be born in mind.

As an alternative to sharing different types of assets, the party who retains the more risk-laden assets may seek a compensating increase in the overall division, although it is difficult to see how an adjustment would be anything other than arbitrary. It might also be argued that this argument is unsustainable as a matter of law: in CR v CR [2007] EWHC 3334 (Fam); [2008] 1 FLR 323 W sought an enhanced share of assets to reflect the likely future increase in their value of H's shareholding. Bodey J rejected the argument:

"…The current value of the shares will be divided equally (conceptually, not literally) between the parties as part of the overall division of their resources. This is because the shares go to make up the overall kitty… She may, for all one knows, take away her half share of the resources and deal with them successfully to produce increasing wealth of a presently unquantifiable amount, just as the husband's shares are likely (as found) to increase in value. … How might such a factor as that be brought into account, if the wife succeeded on her claim to a share in any future increase in the value of the husband's shares? It is difficult to see that it could be, except by tying the parties together for the future in a manner (e.g. by some formula) which would be complicated, disproportionate and unacceptable… In short, a line has to be drawn in terms of the current capital, with the parties being enabled as far as possible and fair to get on with their lives (financially and generally) independent of ongoing ties. I therefore reject the wife's arguments for a share in the likely future enhanced value of the husband's shares in the group." (paras 89-91)

Shareholdings, pragmatism and the wisdom of Charles J
The uncertainty faced by private companies reinforces a number of guidelines laid down by Charles J as to the correct approach that should be taken within ancillary relief.

The first and obvious point to note is that the company valuation is a matter of opinion, "…an art and not a science"17 , in which different experts might legitimately come up with a wide range of figures. The recent case of H v H [2008] EWHC 935 (Fam), involved a dispute over the value of the restaurant business that H had run for 33 years.  Moylan J held that the valuation exercise should not be treated as though it was an exact science justifying a thorough investigations, and that the process of preparing reports had been both expensive and of dubious utility:

"…to seek to construct the whole edifice of an award on a business valuation which is no more than a broad, or even very broad, guide is to risk creating an edifice which is unsound and hence likely to be unfair. In my experience, valuations of shares in private companies are among the most fragile valuations which can be obtained." (para. 5)

In the leading case of A v A [2004] EWHC 2818 (Fam); [2006] 2 FLR 115l Charles J emphasised that in every case involving a substantial shareholding in a private company, the need to 'stand back' and search for a viable and pragmatic solution informed by a general knowledge of company law:

"…it seems to me that in ancillary relief proceedings it is important for the parties and their advisers to look at issues concerning private companies through the eyes of both: (a) persons with experience in and of matrimonial litigation; and (b) persons with experience in and of business and business litigation. For example, if this is done it may quickly become apparent: (a) that there is a wide bracket of valuation; and (b) that there may be a viable and pragmatic business solution which would avoid either or both of the uncertainties and difficulties of valuation and the raising of finance, albeit that it may not involve a clean break" (para. 60)

"I accept that the problem with a business solution is that often it will not involve a clean break and the considerable advantages which flow from that in the context of litigation relating to a divorce would, therefore, be lost if it was adopted. However it seems to me that the parties and their advisers should be clear why they are taking a course which involves the uncertainties and potential unfairness of a result dependent on valuation and the payment of a lump sum (which may have to be borrowed), or a sale".  (paras 62-63)

In such a case, there is an obligation on parties to consider alternatives to their primary wish for a clean break. In D v D and B Ltd [2007] EWHC 278 (Fam); [2007] 2 FLR 653, H owned the shareholding in a holding company (B Ltd) which had a wholly owned trading subsidiary, owned property and 70% of the shareholding in a Ugandan company that did not trade but owned a quantity of African art. A single joint expert valued B Ltd at £2.8m in his first report and, after a good trading year, £4.6m in his second report. Charles J noted that unless a buyer could be found who was keen on buying a mixed trading/ property owning/ African art owning company (unlikely), the extraction of value was going to be complicated and numerous tax issues would arise.

"In cases involving private companies, notwithstanding the differences between divorcing parties and the desirability of a clean break the commercial reality may often be that a commercial/company solution can be found that would promote a result that might be considered to be fairer than a clean break based on valuations… Thus it seems to me that parties and their advisers urging a clean break by reference to valuations of a private company as their primary case will generally, if not always, owe a duty (and in any event would be well advised) to consider commercial alternatives. This is particularly the case when there is, or is likely to be, a significant dispute or a significant uncertainty or a wide bracket on valuation and/or the ability to raise and pay a capital sum without unduly jeopardising or burdening the business or the paying party.." (para. 102, 103)

"I therefore repeat my urging of those involved in ancillary relief cases involving private companies not to confine themselves to an approach based solely on valuation and liquidity (i.e. the ability to raise money to meet a lump sum payment) but to investigate and consider commercial alternatives and periodical payments. In my view it should be practical for this to be done without undue expense in particular with co-operation and the formulation of the correct type of questions." (para. 103-104)

At paragraph 106 of the judgment, Charles J identified a checklist of factors that are likely to be relevant, including the practical issues that flowed in terms of extracting value, the need for the disclosure substantial information: of up to five sets of audited accounts, up to date management accounts if they exist or an up to date assessment by H backed by appropriate records of the current position of the companies an account from H of prospects of companies and plans in future. The likely relevant issues (particularly so in a recession) would be to identify such points as 'is there a market for the shares?'; 'what would the strategy be to sell the shares?' 'what is the correct approach to determining maintainable profits' and consideration of what is the range of appropriate price/ earnings ratio, and how could money be raised from the company when access to credit is restricted.

1  Land Registry House Price Index, from 9.07 (293.4) to 9.08 (269.9): http://www.landregistry.gov.uk.
2  49,784 in July 08 (last available month) compared with 176,631 in July 07: source: Land Registry House Price Index.
3  According to the Federation of Small Businesses, 46% members report a drop in trade, 80% report rising costs and 40 businesses are closing every day: http://www.fsb.org.uk/frontpage/assets/credit%20crunch%20figures.pdf
4  Daily Telegraph 28.11.08.
Miller; McFarlane [2006] UKHL 24; (HL) [2006] 1 FLR 151; Sorrell v Sorrell [2005] EWHC 1717 (Fam);[2006] 1 FLR 497;  Charman v Charman (No 4) [2007] EWCA Civ 503 (No 4) (CA) [2007] 1 FLR 1246
Parlour (CA) [2004] 2 FLR 893; McFarlane (see above); H v H [2007] 2 FLR 548.
7  The FTSE 100 lost 2,288 points (35.89%) of its value between 20.5.08 (6,191) and 28.10.08 (4,086)
8  29.9.08
9  From 376p on 10.10.08 to 446] on 14.10.08
10  300p on 10.9.08 to 85p on 14.10.08, a drop of over 70%
11  $23.92 to $9.68 from 6.10.08 to 10.10.08
12  Share price went from $113 on 8.10.08 to £88 on 10.10.08 to $122.9 on 14.10.08
13  Assuming disposal is post 5.4.08, and taking account of annual exemption of £9,600 (2008-09). Where the assets relate to a business and the Entrepreneurs Relief applies, the applicable rate will be 10%
14  The date of disposal is the date of the court order: http://www.hmrc.gov.uk/manuals/CG1manual/CG22420.htm, Harvey v Sivyer (58TC569).
15  Taxation of Capital Gains Act 1992 s 58(1)
16  i.e. HMRC may regard a couple as separated even though they live under the same roof: Holmes v Mitchell (Inspector of Taxes) [1991] 2 FLR 301
17  e.g. Per Coleridge J in R v R (Company Valuation) [205] 2 FLR 365, para. 17

Part 2 of this article will be published on 10 November


 


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