Responding To Prospective Clients’ Fiduciary Duty FAQs
Whether you are a fiduciary or you are working with a fiduciary, you will probably have some uncertainties about your fiduciary duties. Our reliable attorneys at Nelson Kirkman in Newport Beach can assist you. On this page, you can find some of our answers to frequently asked questions about fiduciary duties.
Do divorcing spouses have an obligation to provide each other with all important financial information?
Yes, each party in a divorce holds fiduciary duties to the other person.
Among these is the responsibility to voluntarily share material information about assets and debts, including community property, investment opportunities, and sources of income. California divorce law recognizes the importance of this fiduciary duty. Not sharing material information before the divorce is finalized can result in severe penalties.
What is a breach of fiduciary duty to a spouse?
Until a divorce is finalized, and property is divided, divorcing parties hold fiduciary duties to each other. The fiduciary duties between married people are wide-ranging, but one important duty during a divorce is to voluntarily share all material information on assets and debts with the other party. This information and document sharing extends to other financial areas such as sources and amounts of income, business opportunities, and retirement accounts. Failure to share this information is a breach of fiduciary duty that can result in such penalties as 100% of the undisclosed asset and attorney’s fees.
What does a breach of fiduciary duty look like?
The fiduciary duty between divorcing parties is broken when one party acts against the best interests of the other party. This can take many forms. Here are two examples:
- A party transferred community property into an investment account without the knowledge of their spouse, leading to a loss of assets. This resulted in financial sanctions as part of their divorce.
- A spouse made a risky and unauthorized loan of community property after the parties were separated, but not divorced. This may be considered a breach of fiduciary duty by the court.
It is important to note windfall gains that occur after a finalized divorce are not a breach of fiduciary duty unless the gain came through fraudulent behavior.
Is a final declaration of disclosure always required?
No, a final declaration of disclosure may not be required if a judgment is executed before a petition for divorce is legally filed. In situations in which a final declaration of disclosure is not required, divorcing parties still hold the same fiduciary duties to each other as in any other situation.
How does a family law court determine the measure of value for a business?
The divorce court may use different measures of valuation for a business in a divorce, such as the going concern value or an investment value. Generally speaking, the court determines the measure of value on the basis of the business not being sold, instead considering the business to be an investment held by the spouse that operates the business.
What is the methodology used by the court to value the business?
The methodology used by the divorce court may vary as long as it does not violate two basic rules: It cannot rely on speculation and must follow all existing family law principles. Two common methodologies concern the capitalization of earnings and capitalization of excess earnings. The court may choose a market approach to valuation, but this methodology faces significant challenges, including finding comparable companies for use in valuation. Other valuation methodologies sometimes used include measuring prior sales or the purchases of interests in the business. California law does not recognize the widely used discounted future cash flow (DCF) valuation methodology because the divorce court value of a business cannot be based on speculation about how the business will perform in the future. In many cases, the valuation of a business owned by divorcing parties requires an analysis of financial performance for the last five years. Some factors in this analysis can be omitted if a valuation expert makes a convincing case that this omission will result in a more accurate picture of the company’s true value.
How does a divorce court treat business goodwill?
If a company owned by the divorcing parties has goodwill, it must be valued and allocated as part of the settlement. Typically, goodwill is calculated based on the performance of the business over the last five years. The treatment of goodwill by the divorce court can vary dramatically based on the particular circumstances of the business. For example, a partnership agreement may limit community interest in goodwill. Other factors that impact the valuation of goodwill include whether the company is public or private. Our team of valuation experts work to determine the best and fairest valuation of a company, including its goodwill.
What is the effective date of the business valuation?
California family law and a significant body of case law indicate the business should be valued as close to the trial or settlement date as possible. There are exceptions to the rule, in some cases the date of separation is used. In other cases, valuation experts provide the court with convincing evidence that a completely different valuation date is most appropriate.
Is an expert required to value specific assets of a business?
Yes, it is generally necessary to have an expert value the specific assets held by a business. The valuation expert responsible for the overall valuation may not have the expertise to properly value such business assets as machinery and intellectual property, so experts in these areas assist in finding the most accurate valuation possible. The valuation may need to address operating vs. non-operating assets, in which case experts determine which assets are truly required to run the business on a day-to-day basis.
How does the court determine controllable cash flow?
Determining the controllable cash flow of the operating spouse can be a major source of contention between experts working for each party in a divorce. One source of this disagreement is determining what portion of the business’s profits can be distributed to the operating spouse without harming the business, such as impacting its ability to cover operating expenses and remain solvent. Typically, cash flow is based on either the income approach or the distribution approach. Cash flow generally includes the operating spouse’s personal income, perks and profits to some degree. Economic depreciation is frequently added to cash flow.
How does the court determine reasonable compensation?
Finding reasonable compensation for the operating spouse can be another source of contention between valuation experts in a divorce. There are two primary approaches to determining reasonable compensation. The first is to consider the annual salary of typical employees who have a similar level of experience as the operating spouse. The second approach is to consider a “similarly situated professional,” which asks what it would cost to hire someone to perform the responsibilities of the operating spouse. This method generally produces a lower goodwill value than the first method.
What areas of valuation cause the most disagreement among experts?
Even if valuation experts are close in their valuation of a business’s tangible assets, they can strongly disagree on the value of goodwill. Several specific topics lead to such disagreements:
- Reasonable compensation
- Multiplier/cap rate
- Controllable cash flow
How can the rate of return on tangible assets differ from expert to expert?
The rate of return on tangible assets is calculated as part of the capitalization of excess earnings valuation method. Although this rate may be called the “industry rate,” it is not standardized. Its calculation differs from expert to expert based on factors they select and can also differ based on economic conditions and interest rates.
How does a multiplier or cap rate impact valuation?
When a business is valued by the capitalization approach, the company’s excess earnings are either multiplied by a multiplier or divided by a capitalization rate as part of the valuation process. The multiplier/capitalization rate chosen is directly related to how risky the business is. A company deemed “risky” due to its operations or industry will have a lower valuation than that of a company considered safer. Since the safer company is considered more likely to generate excess earnings in the future, it receives a higher valuation. Some factors that also impact the multiplier/cap rate include barriers to entry, pending litigation, and how likely accounts receivable are to be collected.
How does a shareholder agreement impact the family law court’s valuation of a business?
When a business is valued by the capitalization approach, the company’s excess earnings are either multiplied by a multiplier or divided by a capitalization rate as part of the valuation process. The multiplier/capitalization rate chosen is directly related to how risky the business is. A company deemed “risky” due to its operations or industry will have a lower valuation than that of a company considered safer. Since the safer company is considered more likely to generate excess earnings in the future, it receives a higher valuation. Some factors that also impact the multiplier/cap rate include barriers to entry, pending litigation, and how likely accounts receivable are to be collected.
If a separate property business increases in value during a marriage, is community property entitled to a portion of the increase?
A business owned by the operator spouse before the marriage is generally separate property. If the business increases in value during the marriage, a portion of that increase may be reimbursable to community property if certain criteria are met. If the value of the business increases during the marriage due, in some degree, to the efforts of the non-operating spouse, then community property is entitled to be reimbursed for a percentage of the increase. This reimbursement value is determined by one of several approaches.
What is the Pereira approach to reimbursing community property?
The Pereira approach, named after the IRMO Pereira decision, determines a reasonable rate of return for the business as it existed at the time of the marriage, and then attributes to community property the remainder of any gain in value. For example, under the Pereira approach, if a business was valued at $10,000,000 at the time of the marriage, then valued at $20,000,000 at the time of the divorce 10 years later, the $10,000,000 increase would be considered community property after the 10 years’ worth of interest was accounted for. When the Pereira approach is utilized, valuation experts are likely to be in conflict over what interest rate should be assigned and whether the interest should be simple or compound.
What is the Van Camp approach to reimbursing community property?
Also called the IRMO Van Camp Decision, the Van Camp Approach involves calculating the community property equivalent owed to a spouse who was under-compensated by the operator spouse during the marriage. If the property increased in value beyond the value of the under-compensation, this added value is considered separate property.
Should excess earnings and accounts receivable be tax impacted?
Tax impacting can be a significant factor in business valuation. Tax impacting is useful in situations when different types of corporations are involved since different types of corporations, such as S corporations, are taxed differently. Importantly, whatever decision is made, both the multiplier and income stream should be considered as pretax or after-tax, not a mixture of the two.
Will the court force the sale of a business as part of the divorce?
It is very rare for a business to be sold as the result of an asset division arrangement in a divorce. Unless there are special circumstances, ownership of the business will be awarded to the operator-spouse who has been running the business. If the divorcing parties operate the business together, it is awarded to the party considered most important to continued operation of the business. The operating spouse does not have the right to cease business operations at the time of the divorce in most cases. If they do, they risk being charged for the value of the business before it was shut down. The court may even award a business to a divorcing party who doesn’t think it should be included in their portion of the community property (IRMO Rives).
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