Money Trap?

There are two intertwined ideas which have coursed through the Divorce Courts in recent years, leaving a trail of uncertainty and confusion in their wake: these are concepts with which we as business valuers may find ourselves enmeshed. These two ideas were then tangled with yet another, but this third point has been laid to rest in the above Court of Appeal judgement. 

The two surviving concepts are:

• Passive appreciation in value of an asset; 
• An elusive springboard to greater value in the future which may exist within a private company.

The third point which has met its end is the idea that the high earning capacity of one of the parties to a marriage may itself be an asset to be treated as non-marital property.

Settlements in divorces are based on the competing concepts of need and sharing. It is only for the very wealthy that the concept of sharing is likely to trump the concept of need.  

It appears to be recognised in the courts that assets brought into a marriage are not marital property for the purposes of the sharing calculations in the event of a subsequent divorce. Therefore those assets, known as the acquest, need to be valued at the beginning and end of the marriage. This then leads on to the unruly twins of passive appreciation and springboards. 

We can consider passive appreciation through an example: one of the parties to a marriage owns a parcel of land with a value of £1,000,000 at the time of marriage; there is a divorce ten years later by which time that land has increased in value to £1,800,000 and has just been sold. That increase in value of some 6% a year is passive appreciation as it has been due solely to the increase in land prices. At the point of divorce the non-marital property relating to that asset is £1,800,000 less the tax and costs on disposal.

The Challenges for Business Valuers – and the Courts

If we rerun the above example, we have to consider what happens if the wife owned, at the point of marriage, shares in a trading company which she heads: at the divorce ten years later a single joint valuation expert determines that the shares had a value at the date of marriage of £1,000,000. The business has prospered and the value at the point of the divorce has increased to £6 million. The total increase in value is clearly £5 million or an average of 19.6% a year. 

That increase in value needs to be divided between the component relating to original value plus passive appreciation (non- marital property) and the balance which we can call active appreciation. The active appreciation has arisen due to efforts made during the marriage and is marital property for the sharing calculations. 

This is a concept which has long had currency in the USA; as the business valuation methods expected by the American courts are those of detailed computation, articles have been written exploring the means of separating the two types of value accretion through forensic examination of the business records. 

The Spring Board – Full of Bounce

Further complexity has been added to the debate in the concept of the Spring board: we can return to the example above - the value of the business owned by the wife at the date of marriage was determined to be £1 million. It is possible that the Court may substitute a value of say £2 million if it so wishes. 

The Court may determine that the asset owned by the wife contained within it many of the components of its future success; the business was a solid but flexible framework and the business was propelled onto the trajectory of successful growth in value due to that spring board effect.

Who Does the Valuation?

In this Court of Appeal case a valuation of £2m as at the start of a marriage, as agreed by two renowned valuers, was doubled to £4 million by the Court.

The cultural background here is one of suspicion of professional business valuations: In the divorce case of H & H [2008] (EWHC 935) it was stated: 

“Further, 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.”

Business valuers are powerless in protest: our professional valuations are designed to reflect all of the hopes and fears for the future; there is the risk of enormous sample selection bias in spying springboards – it will only be in those cases of strong future growth that springboards will be divined to exist; there is as yet no concept that valuers’ opinions will be overturned if a business follows a far humbler path of low achievement; the very notion is based on that miraculous gift of hindsight. 

The Court of Appeal recognised the business valuation technical position: “Mr Pointer correctly submits that a professional valuation calculated by reference to future maintainable earnings will generally reflect the value of any such spring-board.” 

Lady Arden also sounded a cautionary note: “The non-matrimonial asset is the company as it stood at the date of the marriage.”

Computing Passive Appreciation

The case of Jones and Jones was one with which the Court of Appeal strove diligently to straighten the judgement of a lower court replete with a voluminous written decision. There were various competing and conflicting comments on the issue of passive appreciation: passive growth differed from growth due to contributions made during the marriage; an inflationary increase as a passive allowance would only be applicable to assets kept in liquid form; the FTSE All Share Oil and Gas Producers Index should be the yardstick for passive growth in that case. 

There were other comments; the Court should look at what actually happened and not at what might have happened; if only passive growth is taken into account, the law rewards the spouse who buries her non-matrimonial assets in the ground rather than the spouse who actively manages them; the spouse with the non-matrimonial asset is entitled to the fruits of that asset that accrue during the marriage, even if the fruits are the product of activity.

The Decision

The three judges of the Court of Appeal showed a united front in terms of agreeing to a single decision in terms of quantum: the value of the company at the date of marriage was double that of the valuation agreed by two experts; passive appreciation should be recognised; the various figures were all agreed, but for very different reasons. The three judges were united in their differences, in the search for fairness. 

Beneath the surface there was clearly disquiet, expressed in some of the comments of the sagacious Lady Arden. 

Commentary

The use of a FTSE equity index delivers an increase by reference to the increase in the capital value of a group of listed companies. However the index chosen very largely comprises Shell and BP, which pay out significant dividends. If the target company has not paid out dividends, then an intellectually sounder yardstick would be the index adjusted, with the dividends reinvested. 

Lady Arden was of the view that the focus should be on what actually happened, rather than on what might have happened. That focus leads to the conclusion that all of the appreciation should be related to the original asset.  

There are major cultural notes of discord between the valuation community and the Courts: the judges seek the elusive sprite of fairness in divorce allocation: this quest allows for hindsight to be used and for adjustments to be made in order to deliver what is considered to be equitable. 

We can ask how far the concept of passive appreciation should extend: what happens if the shares are in a public company (on AIM or on the main market) and one of the spouses is the CEO? Is that growth entirely passive? This is the feature of the next article, dealing with the case of Robertson and Robertson [2016] EWHC 613.

Andrew Strickland
Consultant