Patrick Dragga is a highly regarded family law practitioner and a frequent lecturer on family law topics, including business valuation, divorce taxation, equitable distribution, and custody. Jeffrey Hannon is recognized as among the elite in the field of family law. He has an active litigation practice, and he is also certified to arbitrate family law cases. In this podcast Patrick and Jeff discuss the importance of prenuptial agreements in high net-worth divorce in Maryland, whether stock options will be divided upon divorce, and the importance of hiring business valuators when couples own a business together and are seeking a divorce.
Hosted by: Diana Shepherd, Editorial Director, Divorce Magazine
Guest speaker: Divorce Attorneys Patrick Dragga and Jeffrey Hannon
Bio: Patrick Dragga and Jeffrey Hannon are partners at the Dragga, Hannon, & Wills law firm in Rockville Maryland. As a founding member of the firm, Patrick has concentrated his practice in family law since 1979. Practicing law since 1974, Jeffrey began focusing exclusively on family law matters in the early 1990s. Both Pat and Jeff have the knowledge and experience to handle the sophisticated financial issues that go hand-in-hand with high-net-worth divorce.
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Read the Transcript of this Podcast Below.
High Net-Worth Divorce in Maryland
Diana Shepherd: Many high-net-worth clients come from families with significant wealth, how common are prenuptial agreements in these kinds of marriages and how well do they hold up in court?
Clients who come from significant wealth sometimes seek a means to protect the family wealth from marital claims. There’s several ways to protect that wealth and one of those frequently used is the prenuptial agreement. Prenuptial agreement usually involves two areas, it protects substantial family wealth from marital claims in the event of a divorce, but it also can affect estate claims in the event of a death of either of the parties.
Such an agreement can be fair and useful and they can avoid hard feelings and confusion, but they don’t always do that. Sometimes they can cause hard feelings and confusion, and we try to avoid that. To do a good job on a prenuptial agreement we must recognize each party’s contributions to the family during the marriage and allow for the growth of the marital estate, while protecting the family wealth from any such claims in the future.
Prenuptial agreements require certain formalities that must be filed in order to ensure enforcement down the road. If executed with proper formality these agreements are usually enforceable in Maryland courts. Particular states other than Maryland, as well as Maryland, have different requirements that must exist to ensure enforceability. Maryland seems to favour enforcement of such agreements.
Jeff, does a premarital or prenuptial agreement override normal property division rules?
Generally speaking when someone is looking to enter into a prenuptial agreement, they are trying to accomplish just that. They’re trying to limit the remedies that the court will have if the marriage fails and they’re involved in a divorce proceeding. In order to clarify which assets will be included in a divorce action, they use a prenuptial agreement to excise certain assets from consideration.
Now this is most commonly seen when someone has accumulated a large estate prior to getting married, either by their own efforts or the efforts of their family. They’re trying to keep that out of the mix and they’re trying to make it clear to the new spouse that that won’t be included in any claim that might be made in the future should the marriage fail. It’s important that if they have an agreement that they focus on the fact that any asset they may have prior to the marriage could, and is likely to increase in value during the marriage. They’re trying to exclude typically that increased value.
This is particularly true if someone has a family business that will grow, or an individual business that will grow; or, if they have an investment, whether it be in stocks, bonds and what have you that will grow. A retirement account will grow during the marriage, and it’s important for the parties to consider in a prenuptial agreement whether or not they want to include that growth as part of the marital estate.
Also a prenuptial agreement can be used to limit the right to support. Now a lot of things happen in a marriage; the longer the marriage, the more complicated the facts. People use prenuptial agreements typically to limit their exposure to an alimony claim. If you have a high earner or someone who is going to be the breadwinner in the marriage and they can see that going in, then they want to consider whether they should try to reduce their exposure to alimony by use of a prenuptial agreement.
The objective is to consider that if the marriage fails there could be such a claim. You can in a prenuptial agreement limit that claim. You can sets amounts of alimony that would be earned per se if you’re married for five years, 10 years, or 15 years. Whereas if you don’t have an agreement like that, the court will make the determination based on the facts presented at the time of trial.
Now it’s very important to remember that because you’re involved in limiting the estate, the marital-estate, and you may be involved in limiting the awards of support that the agreement has to be fairly negotiated. It’s almost essential that both sides be represented at the time the agreement is negotiated and that there be complete disclosure by both sides as to what assets there are at the time of the marriage.
It has to be negotiated in advance of the marriage, a reasonable period before. You don’t want to be negotiating an agreement and signing it during the wedding practice ceremony, it’s got to look like it’s fair and everyone’s had a chance to consider the terms, negotiate the terms, and discuss their respective positions with a legal representative. That way an agreement that is thoughtfully set out will withstand any attack in the future. Maryland courts are inclined to support these agreements but they have to be fair.
Pat, the rule of thumb in divorce is that you should ask for five years of financial information when seeking to value a company. Could using five years be misleading because the trend in a specific industry or in the economy generally, is longer or shorter than five years?
That’s a very good point. Like every rule of thumb, the five year financial information requirement or request is a good starting point in determining what is the appropriate amount of disclosure that would lead to a fair business valuation.
Where that comes from is this idea of a five-year weighted average to determine appropriately, and not by a spike or a trough, what the profits or income from a particular business happen to be. Whether this particular five year period is good with respect to this particular business of course is something that you have to evaluate independently.
What we try to do is find out as much as we can about the individual business before we seek the particular information to determine whether something like five years or a different term would be more appropriate, particularly in small businesses you have many opportunities to see changes with respect to the business, retirement of an important or key employee, a particular kind of business that has ebbs and flows. All of these things can determine what is the most appropriate thing, what’s the most appropriate time and amount of information necessary for evaluation of a business.
Jeff, is a degree earned during a marriage a marital asset in Maryland? How about a medical license or a license to practice law earned during the marriage? How would these be valued?
Well, unlike some states, Maryland had made pretty clear that licenses, like a medical license, dental license, or a license to practice law is not an asset in and of itself. It does not add value to the marital estate. So, the simple answer to the first part of your question is no. However, you can include information that pertains to the acquisition of a medical license or a license to practice law, any kind of professional degree that leads to the establishment of a business, and a means by which to earn a good income. That can be included in the discussion of a divorce.
So, even though the license itself is not marital property and can’t be valued, and adds no value to the marital estate in Maryland, the business that the license supports can be valued and can add value to the estate. So, if somebody has a dental practice or an ophthalmological practice, that can be valued, and if it’s a practice involving a number of professionals, then you have to take into consideration the structure of the business and what interest or power that individual has, but that’s much like valuing a business.
More important than that, say that you’re trying to get facts that pertain to an individual, this is the spouse who doesn’t have the practice or professional degree; the efforts that they made to support the other spouse when they were in law school or when they were in medical school, and that they worked day and night to pay the bills, pay the tuition or otherwise support the family while the other person was occupied with pertaining their professional degree; those facts are still useful. They are particularly useful in the determination by the court of a monetary award when the court tries to determine how much they want. The court identifies the marital property and then they value it, then they divide it. They use a monetary award most commonly to divide it in some equable way.
When they do that the court has to consider a number of factors, the 11th factor that they consider is one that basically is a catch-all, where they can consider any facts or circumstances that they feel they should consider in order to reach an equitable conclusion. Since we’re in a court of equity, those facts have value. The better the facts the more value they have. If you can convince the court that if it were not for the efforts of the nonprofessional spouse, the professional spouse would not have accomplished as much, then you might get more traction in requesting a greater share of the marital estate.
In conclusion I would say that even though the license itself has no value and doesn’t increase the value of the marital estate, the business that the license allows the individual to have could have value and that is in the marital estate. If a person is looking for a bigger piece of the pie, they can still argue those supports they made to support the individual getting the license. Usually that occurs early in the marriage.
Another point that comes up is of course if the nonprofessional spouse is looking for alimony. A court has to consider contributions to the marriage, monetary and non-monetary contributions. Monetary contributions are those where you go out and make a living, you get a paycheque and the non-monetary contributions are the ones where you stay at home or you’re raising the children, you’re keeping the house, you’re fixing the car, you’re mowing the lawn, but those could also include the support of someone’s effort to obtain a professional degree.
So even in the context of support or an alimony claim, the efforts of the nonprofessional spouse to support the professional spouse early in their career as they’re getting established and ultimately become the breadwinner and the major economic force, can be taken into consideration. The client should never lose sight of those facts and the lawyer should never hesitate to get that information from the client and put it to the best use.
Pat, if one or both spouses own a business, is it always necessary to hire a business valuator? I’m wondering if there’s a minimum size or dollar value to make it a worthwhile exercise.
Interestingly you’re not the only one who is concerned whether or not a formal valuation is necessary in a divorce case. That’s usually a cost benefit analysis and unfortunately there is no guiding principle to say that this level of business valuation we’re not going to bother with. Much depends on the feelings of the clients and how they feel about the value of the businesses and how important it is in the acquisition of marital property and as a percentage of the marital estate.
What we try to do is we try to find alternatives in appropriate cases. Obviously in a very substantial business a formal valuation would be required. When it’s a close question we try to find alternatives. Much depends on what the clients can agree to, we certainly don’t want to pay the cost of two valuators if the clients continue to disagree. We hope we can agree on one evaluator if evaluation is necessary. Or we can look at perhaps an accountant for the business if we can find somebody that both people seem to trust who might be able to give us an informal estimate of the value of the business without a formal valuation.
What we’re trying to do here is, in most cases, determine a going concern value for a business that might be different from say an adjusted book value. When I say different I mean more valuable. That’s where you’ll always run into the necessity for finding someone impartial to put a value on the business because the person who runs the business doesn’t think it’s worth anything, and the person who’s out of the business thinks it’s worth a great deal in many cases.
One of the issues that Maryland imposes upon us in this area is something called personal goodwill, that is maybe an asset, but it’s an non-distributable asset, that is to say it’s not marital property. So in many cases, with a small business particularly, we need formal valuations to try to help us determine what if any part of the value of the business can be assigned to personal goodwill and thus not distributed as part of the marital state. These are difficult questions, they add to the complexity and expense of the undertaking but in the appropriate cases totally essential. Unfortunately we don’t know a minimum where that valuation would not be appropriate.
Jeff, if one spouse receives stock options at work, are they considered assets to be divided during divorce? How does executive compensation including stock options, RSUs, RSAs, phantom equity grants, etc. affect a divorce settlement?
Well, as most of us probably know by now the marketplace, and the Internal Revenue Service, has a driven certain industries into the business of making it attractive to the employee, not necessarily restricted to executives or the employees at the top end of a business to earn income in different ways. The most common ways that’s done is with stock options, restricted stock units, deferred compensation, bonuses that are earned over time, particularly in the biotech industry and in the tech industry this is a very common form of compensation.
In our area we see a lot of individuals who have earned stock options during the course of their employment and they get restricted stock units. They are not the same and they’re not handled tax wise the same. But the objective of the employer is the same. The employer’s trying to accomplish two things, they’re trying to incentivize the employee to have a stake in the business so if the business does better, the stock prices goes up. So everybody wants the business to do better because they have a certain number of stock options awarded to them every year, and a certain number of restricted stock units.
The second part of it is that they also want to keep the person there. They don’t want employees jumping out of the business every year, every two years, every three years, so they fashioned the restricted stock units, and the stock options and in many instances deferred compensation to vest over a period of years. So, even though you may get an award you don’t get all of the award the date that the award is given. Rather you earn it by staying employed, maybe you get a third every year. So, for a course of three years you become totally vested. Same things could be true of a restricted stock unit, it could be five years, it could be seven, it can be 10. Whatever the agreement between the employer and the employees set forth clearly in a stock option plan or restricted stock unit award letter, all the terms are there and you sign off on it when you get the award.
Now this all relates back to the divorce action. You never know when you’re going to get a divorce thank god, but when you do get a divorce, Maryland declares the marital estate to have its value at the time the divorce is granted. There are few exceptions to that. Therefore the vesting schedule on stock units, restricted stock units, stock options as well as deferred compensation awards become critical because if it’s not vested it doesn’t have any value. It’s based on future work which hasn’t yet occurred.
The court looks carefully at these kinds of assets. They do have value but the value can be diminished in any number of ways. The most important way it can be diminished is that some part of it is not yet earned, not yet vested. The other thing that affects these things is that they are heavily taxed, usually the individual’s tax rate who received them. So they have a net value of taxes as well as any reduced value because they’re not fully vested.
This becomes a very complicated part of any divorce action where one of the spouses, or both, have these various forms of sophisticated compensation that augments their wages. Usually, particularly if the company’s in any way successful, these particular assets have a great deal of potential value. You have got to be careful to seek a representative, a lawyer, who has a working knowledge and experience in the area of dealings with individuals who have sophisticated ways of being compensated.
These kinds of actions, divorce actions, have to consider the value of these assets, and because of the fact that they are impacted by taxes and impacted by a vesting schedule, it is not easy to determine what their value is. When you are dealing with a divorce, everyone looks to settle the case if they can. In an agreement posture you have an infinite number of creative ways to deal with things such as stock options and restricted units.
In some cases they can be transferred to the spouse, in many cases, they can’t be, that’s controlled by the agreement. But even if not transferred, the language of the agreement can be designed to allow the spouse who doesn’t have the awards to order the other spouse to elect their share. Or go along for the ride and see if when they do mature and their has to be options. They have to be cashed in, usually that’s about 10 years, then they just sit back and wait for the 10 years to go by and they get their share at the back end.
When you get outside of an agreement and you’re in the courthouse, the remedies are far more restrictive. There’s little the court can do. They can value them and that’s tricky. Usually you might have to have an expert to explain the tax consequences and then they can divide that value. But they typically don’t see themselves as having the power to award a spouse stock options or restricted stock units. The value is set at the time of divorce, just like you might value a house and they take into consideration the vesting, the fact that certain ones have invested. They take into consideration the tax consequences and even that is quite tricky.
So, when you have a lot of these sophisticated means of augmenting people’s income, it’s a big incentive for both sides to settle and reach an agreement because the court is not really the best place to be. If they have to be there, the answer to your question is they do have value, they are assets of the marriage, that value can be divided. You, the lawyer representing the spouse, who is looking for this value, has the job of determining the value and including every fancy means of augmenting an executive’s income as possible to be included in the marital pie.