From left: Todd Feinsmith, Lee D. Sanderson and Laura Gibbs
Introduction
Marital estates — particularly those of significant value and complexity — may be undervalued by Probate Court practitioners who fail to consider principles of corporate separateness in business valuations and financial analyses. Too often, divorce attorneys, and even valuation experts, consider the assets of a marital estate as an integrated whole without giving due consideration to the impact that corporate separateness may have on third-party claims against business assets that are part of the marital estate and the significant impact it can have on the value to which a divorcing spouse is entitled.
The assets of complex and valuable businesses are typically held in a structure of limited liability companies (e.g., corporations and LLCs). These legal entities are commonly utilized and intentionally created by their owners to shield themselves from personal liability, and importantly, to shield each entity from the liabilities of its affiliates. Segregating — or “siloing” — assets and liabilities on an entity-by-entity basis isolates risk and protects valuable assets from being infected by the liabilities of troubled, or even insolvent, entities within a corporate enterprise.
Frequently, however, in the context of domestic relations cases, an overly simplified “netting” of assets and liabilities is performed. Sometimes, this is done for the sake of ease or simplicity. Other times, it is because the financial statements for the businesses are prepared on a consolidated basis. In each case, failure to give due consideration to corporate structure, legal separateness and, above all, creditors’ rights principles can devalue assets within the marital estate in a way that may be legally incorrect and detrimental to the party who does not own the business interests. As a result, value that would otherwise be available for an equitable distribution of property is sometimes misjudged or overlooked altogether.
Family court practitioners who may not be as experienced with corporate law and creditors’ rights principles should undertake a careful analysis and seek guidance from a specialist in this area of the law to determine where value resides in a business to ensure that the marital estate is not incorrectly undervalued to the detriment of their client.
A. A Hypothetical To Illustrate The Importance Of The Issue Of Corporate Separateness
Assume that a husband and wife are divorcing and the marital estate includes the husband’s business, which is operated through two LLCs, referred to herein as Companies A and B. Assume further that Company A has a value of $10 million, whereas Company B is insolvent and has debt that exceeds the value of its assets by $8 million. Importantly, Company B is the sole obligor of such debt, and it is non-recourse to Company A.
1The husband erected this corporate structure utilizing LLCs to ensure that the assets of Companies A and B remained separate from each other so that if one entity became financially troubled, the other would not be negatively affected. Likewise, there is also the concomitant benefit that the husband is (and any other equity owners are) insulated personally from the liabilities of his companies.
The consolidated balance sheet for this business enterprise shows total net assets of $10 million and debt of $8 million. As a result, the husband’s counsel in the divorce proceeding takes the position that the marital estate has a value of $2 million, and it is that amount that counsel proposes should be divided among the spouses. The husband’s counsel arrives at this position by netting the $8 million “negative” value of Company B against the $10 million “positive” value of Company A. The husband contends that this is appropriate, after all, because the businesses operate as a unified whole, and the books of Companies A and B are consolidated for accounting purposes.
This “netting” approach presumes that shares of an insolvent company have a
negative value — that is, a
value less than zero — that can be deducted from the value of marital assets that have positive value. In actuality, this conclusion is simply incorrect as a matter of law, and it unfairly diminishes the actual value of the marital estate — from $10 million to only $2 million — to the wife’s significant financial detriment. The legal analysis that follows demonstrates why this is the case.
B. Relevant Legal Principles
1. The Law Insulates Business Owners and Affiliate Entities
A fundamental principle and purpose of an LLC is to shield its members and affiliates from debts and liabilities incurred by the LLC itself. To that end, Massachusetts General Laws Chapter 156c, Section 22 provides:
Except as otherwise provided by this chapter, the debts, obligations and liabilities of a limited liability company, whether arising in contract, tort or otherwise, shall be solely the debts, obligations and liabilities of the limited liability company; and no member or manager of a limited liability company shall be personally liable, directly or indirectly, including, without limitation, by way of indemnification, contribution, assessment or otherwise, for any such debt, obligation or liability of the limited liability company solely by reason of being a member or acting as a manager of the limited liability company.
Similarly, with respect to corporations, Massachusetts General Laws, Chapter 156D, §6.22 provides:
Unless otherwise provided in the articles of organization, a shareholder of a corporation shall not be personally liable for the acts or debts of the Corporation …
The decisional law in the commonwealth is likewise well settled on this point.
See Evans v. Multicon Const. Corp., 30 Mass. App. Ct. 728, 732 (1991) (holding that the corporate form should be honored except in “rare particular situations” to prevent gross inequity caused by “fraud” or “confused intermingling”).
It is because of this limitation on the personal liability of members (and shareholders) that business owners frequently utilize LLCs (and corporations) to protect themselves and affiliated entities. This is especially prevalent in the real estate context, where developers and owners seek to isolate or “silo” liabilities on an entity-by-entity basis so as not to contaminate a performing, solvent asset or entity with the debts and obligations of an underperforming, insolvent asset or entity.
Moreover, in most instances where a corporate structure has been erected to achieve corporate separateness and insulate equity owners from liability, care will have been taken to ensure that the governing corporate documents negate the equity owner’s obligation to contribute capital or otherwise assume responsibility for the debts of the entity or its affiliates. Such provisions in the governing documents only underscore the fact that valuation of assets within the marital estate should be considered on an entity-by-entity basis without discounting the value of particular entities based on debts for which they are not obligors.
2. Is There a Legal Basis to Pierce the Corporate Veil?
Importantly, the law honors this concept of corporate separateness and presumes that the so-called “corporate veil” may not be pierced absent a justifiable legal basis to do so.
See Pepsi-Cola Metropolitan Bottling Co. v. Checkers, Inc., 754 F.2d 10 (1st Cir. 1985). Indeed, the burden is on a third-party plaintiff/creditor to show why a legal entity should be disregarded, and the legal presumption is that separateness should be honored.
See, e.g., Attorney General v. M.C.K., Inc., 736 N.E. 2d 373, 380 (Mass. 2000).
In a divorce proceeding, it would make little sense for a spouse to take the position that the corporate veil should be pierced for several reasons. First, unless a creditor has actually brought an action to pierce the veil to collect a debt, the issue isn’t even ripe for determination by the Probate Court. Second, it would be inapposite for that spouse to contend that the corporate veil should be disregarded because they deliberately and purposely erected the corporate structure to ensure that neither they personally, nor any corporate affiliates, would be liable for the debts of the limited liability entity. Consequently, if the spouse seeking a consolidated valuation makes such an argument, they would be doing so at their own peril and to the detriment of other shareholders (or LLC members) who would lose the benefit of the protections afforded by a carefully constructed legal structure.
2 3. Valuation Standards Mandate Consideration of Corporate Structure, Legal Separateness and Creditors’ Rights
A common mistake in business valuation is failure to properly identify the subject interest and then assess the rights attached to the interest. This can result in an inappropriately low value. The first step in a valuation analysis is proper identification of the subject interest. The question “what exactly is being valued” must be answered accurately to comply with the Statements on Standards for Valuation Services promulgated by the American Institute of Certified Public Accountants (AICPA) (the “Valuation Standards”).
Whether the subject interest is a direct ownership in an asset, ownership of LLC units, ownership of corporate shares, or ownership of an intangible asset can have a material impact on both the accuracy and the relevance of an analysis.
According to Valuing Small Businesses and Professional Practices, Third Edition, by Shannon Pratt:
Much of the confusion and apparent disagreement among appraisers and appraisal reports arises simply because it is not clear exactly what asset, property or business interest is to be valued. To determine the applicable valuation approaches, methods, and procedures, exactly what is to be valued must be made clear. An important determination is whether the stock or the assets of the business are to be valued.
Stock represents an indirect ownership interest in whatever bundle of assets and liabilities exists in a corporation. Stock ownership is quite different from the direct ownership of assets and the direct obligation for liabilities.
Id. at p. 22.
Once the subject interest is properly identified, the rights attached to the asset need to be analyzed. When the valuation of those rights is contingent upon legal matters, such as whether shares in an LLC or corporation can ever be worth less than zero, or whether the rights of creditors have priority over the non-business-owner spouse, it is incumbent upon the valuation analyst to obtain a legal opinion. Failure to do so can undermine the credibility of a valuation analysis and potentially undervalue an asset.
Moreover, not only does the law support a valuation approach that takes into account corporate structure, legal separateness and creditors’ rights principles, but the AICPA Valuation Standards mandate that these elements be considered as part of the valuation. For example, Section 100.27 of the Valuation Standards, in pertinent part, provides:
The valuation analyst should … obtain sufficient nonfinancial information to enable him or her to understand the subject entity, including … [o]rganizational structure. (emphasis added)
Further, Section 100.28 provides:
The valuation analyst should obtain, where applicable and available, ownership information regarding the subject interest to enable him or her to … understand other matters that may affect the value of the subject interest, such as: … [f]or a business [or] business ownership interest, … [the] operating agreements, … loan covenants, … and other contractual obligations [e.g., loan obligations] or restrictions affecting the owners and the subject interest. (emphasis added)
Additionally, Section 100.34 indicates that in the context of an asset valuation:
When using … [the] asset method in valuing a business [or] business ownership interest, … the valuation analyst should consider, as appropriate [the] [i]dentification of the assets and liabilities. (emphasis added)
Based on the foregoing, it is clear from the AICPA Valuation Standards that consideration of the law governing corporate separateness as dictated by the organizational structure of the business, limitations on liability as may be set forth in the operating agreements and governing documents of the company, and the application of creditors’ rights principles all should be central to the valuation exercise.3
C. Application of the legal principles to our hypothetical
It is not uncommon in a divorce proceeding involving the valuation of a business with a complex structure composed of multiple legal entities for a party — typically the one trying to downplay the value of the marital estate — to treat the business as a consolidated whole even if it is composed of multiple legal entities. In our hypothetical, the husband adopts the position that the assets of Company A and Company B should be consolidated to determine the “net” value of the marital estate.
This “netting” approach, however, is counter to applicable law because it ignores the well-accepted doctrine of corporate separateness and ignores whether debt
actually burdens specific assets of the marital estate, or not, as a matter of law. In our hypothetical, Company A has a value to the marital estate of $10 million irrespective of the debt encumbering Company B. Company B, on the other hand, has a value of zero dollars to the marital estate, and not less. Put another way, simply because Company B is insolvent does not mean that it should devalue Company A’s value to the marital estate to the extent by which it is insolvent where its debts are not recourse to Company A.
4
This is particularly true on equitable grounds where, in our example, the husband went to great lengths to erect a corporate structure that established legal separateness between the entities through which his business is conducted. The value of each entity is impacted only by the debt for which it is responsible, and not the debt for which only its affiliate is responsible. The obligation of an affiliate to pay its own debt cannot, as a matter of law, be imposed on other affiliates that are not obligors of that debt. To lump assets and liabilities together by performing a legally impermissible consolidation or “netting” is contrary to the well-established principles of corporate separateness and creditors’ rights law. Moreover, doing so ignores the Valuation Standards that are prescribed by the AICPA. Even worse, it unfairly devalues the marital estate to the detriment of the other spouse.
Practice Tip
When you are called upon to assess a marital estate that consists of a complex business enterprise, it is advisable for (and arguably incumbent upon) domestic relations lawyers and valuation experts alike to consult with corporate counsel who is experienced with the laws governing corporate separateness, creditors’ rights and limitations on liability. Through detailed analysis of the corporate structure, governing documents and applicable law, determinations can be made regarding the significant impact these considerations may have on value.
Todd Feinsmith is a partner in the Corporate Reorganization Group of ArentFox Schiff LLP. He is the past managing partner and national co-chair of the Corporate Reorganization Group of another national law firm.
Lee D. Sanderson is a Certified Public Accountant and the principal of Valuation Forensics LLC.
Laura Gibbs is a domestic relations lawyer and a founding partner and the managing partner of Gibbs Heinle Maiona LLP.
1. An example of such debt could be a bank loan where Company B — but not A — is the maker of the note. Alternatively, the obligations could be trade debt or any other financial obligation where Company B is the sole legal obligor.
2. It should be noted that in certain very specific circumstances — specifically bankruptcy proceedings that occur pursuant to Title 11 of the U.S. Code — the law recognizes that separate legal entities may be consolidated with each other for the purposes of satisfying the debts of creditors.
See In re Augie/Restivo Baking Co., 860 F.2d 515,518 (2nd Cir. 1988). However, consolidation under such circumstances is plainly distinguishable from consolidating assets and liabilities of otherwise-separate legal entities for the purposes of valuing a marital estate in a divorce proceeding. First, substantive consolidation is a remedy that is applied in bankruptcy proceedings based on equitable powers conferred on the Bankruptcy Court pursuant to Section 105 of the U.S. Bankruptcy Code.
Id. The remedy of substantive consolidation does not apply in ordinary civil proceedings except in the form of veil piercing (as discussed above). Second, even where bankruptcy courts have permitted substantive consolidation, the case law makes clear that it is an extraordinary remedy that should be used “sparingly.”
See In re Bonham, 229 F.3d 750, 767 (9th Cir. 2000). Indeed, it is widely accepted that it should only be used where (i) creditors dealt with the entities as a single economic unit and did not rely on their separate identity in extending credit, or (ii) the affairs of the entities are so entangled that consolidation will benefit all creditors.
See Augie/Restivo at 518. Hence, the inapplicability of substantive consolidation outside of bankruptcy underscores the fact that it is not appropriate to consolidate legally separate entities in a divorce proceeding for the purposes of valuing a marital estate.
3. It should be noted that there may be instances where an insolvent or financially troubled company confers a value upon its affiliates, and the entire corporate enterprise, that exceeds its value on a stand-alone basis. Consider, for example, a manufacturing business that benefits from vertical integration of a particular subsidiary that happens to be financially troubled. It may be the case that the financially troubled subsidiary manufactures a particular part used in the production of an item at a loss, but that part is critical to the manufacturing process and could not be sourced from a third party in sufficient quantity or quality, or for a more favorable price. In such case, due to the symbiosis resulting from vertical integration, the financially troubled company may nevertheless have a value to the business enterprise that exceeds its worth on a stand-alone basis.
4. Of course, if the debt of Company B is recourse to Company A (as would be the case, for example, if Company A guaranteed the debt of Company B), then such debt would have a bearing on Company A’s value.