It is common for divorce settlements to include a transfer between spouses of an ownership interest in a private company, but the frequency of this transaction does not mean that it should be taken lightly. In fact, transferring a private company ownership stake in a divorce settlement often includes heightened business risks beyond the sale of a business interest between two unaffiliated parties. This post therefore focuses on critical business risks present for both the spouse acquiring the ownership interest and the spouse who is transferring the interest in the company. These business risks should be discussed with the spouses’ family law or business counsel to ensure that they are addressed in the parties’ divorce settlement.
Business Risks to Spouse Who Acquires Company Interest in Divorce
The following are three of the most critical points the spouse acquiring the private company ownership interest will want to include in the divorce settlement and related contracts that confirm the transfer of this interest, and they are discussed below:
- Confirming Inspection Was Completed
- Including a Broad Anti-Fraud Provision
- Documenting Full, Complete Transfer of Interest
- All Inspections of Relevant Materials Completed
The acquiring spouse (“Transferee”) wants to avoid all future claims by the spouse who is transferring his/her ownership interest in the business (the “Transferor”) as part of the divorce settlement. Therefore, the Transferee will want to secure representations from the Transferor in the settlement documents confirming that he/she had both access to and time to review all financial records and business documents related to the company at issue in the transaction before following through with the Transferor’s transfer of the ownership interest. These representations should help to cut off future claims by the Transferor that he or she was deprived in any way of the information necessary to make a fully informed decision about the consideration that the Transferor received before transferring his/her interest in the company to the Transferee spouse.
Inclusion of Broad Anti-Fraud Provision
In Texas, spouses owe each other a fiduciary duty during their marriage when they engage in business dealings together. That fiduciary duty is extinguished, however, once either spouse files a divorce proceeding, but the Transferee spouse should nevertheless insist on securing broad representations from the Transferor spouse that, in entering into the divorce settlement, he/she is not relying on any promises, representations or consideration by the Transferee spouse that are not fully set forth in the settlement agreement.
This type of term in the Settlement Agreement is commonly known as an “anti-fraud” provision, because its purpose is to cut off any later fraud claim by the Transferor spouse after transferring his/her interest in the company based on the notion that the Transferor was misled in some manner by the Transferee, which induced the Transferor to enter into the transaction. Therefore, this anti-fraud provision confirms that the Transferor has agreed to receive only that specific consideration that is documented and expressly set forth in the terms of the divorce settlement agreement.
Documentation of Transfer of Full Ownership Interest
The final issue of concern to the Transferee spouse is to ensure that the entire interest of the Transferor spouse is obtained in the transaction. The Transferee will want to confirm that all right, title and interest in the company held by the Transferor is transferred in the transaction and also confirm that the Transferor does not retain any interest whatsoever in the company, or any of its assets. In many divorce settlements the Transferee spouse does not have funds at the time of the divorce that are sufficient to pay for the full value of the 50% interest held by the Transferor spouse in the company, and the settlement payment must therefore be made in a structured buyout. Even in the case of a structured buyout, however, the Transferee will want to insist that the full equity in the company held by the Transferor transfers at the time of the divorce. This transfer of the equity is necessary at the time of the divorce to ensure that the Transferee does not become subject to any future claims by the Transferor related to the operation or performance of the business after the divorce has become final.
If the Transferee lacks the funds to pay for the full value of the Transferor’s interest at the time of the divorce, however, the Transferor may insist on securing some form of collateral during the buyout period to ensure that full payment is made. The collateral could include a secured interest in the stock or membership interest that is being transferred. If the stock or membership interest is used as collateral, a default in payment by the Transferee would permit the Transferor to initiate a judicial foreclosure to recover the stock or membership interest that was transferred to the Transferee.
Business Risks to Spouse Who Transfers Company Interest in Divorce
The spouse who transfers his or her ownership interest in the company to the other spouse also has several key business points this Transferor will want to include in the divorce settlement, and three of these important business terms are listed and then discussed below:
- Securing Representation of No Imminent Sale of Company
- Including Broad Release Provision from the Company Itself
- Obtaining Indemnity From Company Against Future Claims
- Representation that No Sale of Business is Imminent
The Transferor does not want to be paid for his/her interest in the business only to find out that if the Transferor had waited a matter of weeks or months, the company would have been sold for a much higher value than the seller/transferor received for his or her interest at the time it was purchased by the company. The way to avoid this is to secure an agreement that if the business is sold within some set period of time after the divorce, perhaps one year, the Transferor will receive an additional payment equal to the additional amount that the Transferor would have received if he/she remained an owner at the time of the sale. This contract term is called a look back provision and is common in purchase/sale agreements.
If the Transferee will not agree to include a look back provision in the divorce settlement, the Transferor may insist on securing a representation that no sale of the company is imminent or will take place within a specified period of time after the transfer is made. This term gives the Transferor protection of a similar nature to the look back provision.
Transferor Spouse Should Receive a Release from the Business
Most divorce settlements include a mutual release of claims in which each spouse releases all claims against the other spouse before the date of the settlement. When a business interest is involved, however, the Transferor spouse should also require the business to provide that spouse with a release of all claims by the business. This will preclude the Transferee spouse from filing any claims by or on behalf of the business against the Transferor after the stock in the business has been transferred and the Transferee now has full control over the company. In sum, the Transferor needs to secure a full and broad release from the company, as well as a similar broad release from the Transferee, as an essential part of the divorce settlement.
Transferor Spouse Should Also Receive Indemnity From the Business
For all of the same reasons that the Transferor should demand a release from the company, the Transferor should also insist on being indemnified by the company if the Transferor is named as a defendant in any later lawsuit filed after the divorce settlement is completed. After the transfer takes place, the Transferee is now likely the full or certainly the majority owner of the business, and the owner should be required to provide the Transferor with an indemnity against all claims by third parties unless the claim itself is the direct result of some bad faith action or willful misconduct by the Transferor. Including an indemnity provision in the divorce settlement provides the Transferor with a reasonable measure of protection in the event that the Transferor is named in any lawsuit related to the company at issue.
In our entrepreneurial society, spouses frequently have ownership stakes in businesses that they acquired during the marriage, and which will then need to be addressed when a divorce is filed. While transfers of ownership interests are quite common in divorce proceedings, these transfers must be handled with a significant amount of care and precision. If the divorce settlement fails to address the likely and probable scenarios involved in the transfer of a business interest from one spouse to another, the divorce decree will not signify then end of all disputes between the parties. Instead, the parties may find themselves embroiled in another lawsuit over business issues that is at least as contentious as their divorce proceeding.