The Business Divorce: Maximizing Value For Clients in Property SettlementsHouston Bar Association - Family Law Section, October 7, 2015

Charles RubioPartnercrubio@diamondmccarthy.com

(713) 333‐5127

Ladd Hirsch Partnerlhirsch@diamondmccarthy.com

(214) 389‐5323 

Today’s Presenters from Diamond McCarthy LLP

Settlement Counsel – Adding Value to the Team

Scenario #1:

Divorcing couple have substantial ownership interest in private company – illiquid value

Scenario #2:

Valuing the business (or interest in the business) is too difficult, expensive or unsuitable

Situations Where Settlement Counsel Add Value

Scenario #3:

Divorcing parties each desire to continue holding ownership interest in business after divorce

Situations Where Settlement Counsel Add Value

Changing Texas Legal Landscape: Claim for Shareholder Oppression Limited

Ritchie v. Rupe, 443 S.W.3d 856 (Tex. June 20, 2014)

New standard for shareholder oppression

No buyout for proving shareholder oppression, only appointment of a receiver

Contract Buyouts Will Be Enforced

Cardiac Perfusion Servs., Inc. v. Hughes, 436 S.W.3d 790 (Tex. June 27, 2014)

Don’t accept a buyout at book value

Dividend Plan is Essential

Argo Data Res. Corp. v. Shagrithaya, 380 S.W.3d 249 (Tex. App.—Dallas 2012, pet. denied)

Get a distribution plan

Benefits From Agreed Division of Business Interests

• Parties decide terms of property division, not court

– Court’s “solution” may make both parties unhappy

– Judge can: (i) require sale of business, (ii) grant full ownership of business to one spouse, or (iii) make couple co-owners of business

– Court’s order may create significant practical problems

– Couple can decide the best way to divide their ownership interest

• Settlements are potentially quicker and less expensive

Property Division Options

Promissory Note (Debt)Requires valuation to establish principal amountConsider term, interest, amortization, and default events 

Hybrid InterestsPreferred EquityProfits InterestCombination of Debt and Equity 

Equity InterestGenerally requires most information and involvement to vote on owner matters

Information and involvement needs vary with different type of interests

Secured Promissory Notes• Perfection of security interests in collateral

– Real property records (County Clerks Office)

– UCC-1 Financing Statement (Texas Secretary of State)

– Account control agreement

• Only way to perfect a security interest in a bank account

– Possession/constructive possession

Business Bundle of Rights (and Responsibilities)

Decision Making Power

Management Liability 

Distributions

Capital Calls

Transfers 

Compensation 

Goodwill

Business Opportunities 

Intellectual Property

Dispute Resolution

Decision Making Power

Management Liability  

Management Control

Co-Ownership Deadlock Scenario

W H

GP

Partnership

49.5% 1% 49.5%

50%50%

Decision Making Power• Governance documents generally specify who has authority to make

business decisions and the process for making decisions

• Under Texas law, the potential legal avenues the deadlocked owner include: (i) seeking appointment of provisional director to break the deadlock, or (ii) seeking appointment of a custodian or receiver

Concerns to Balance

Controlling spouse has Authority to enter into ordinary course transactions

versus

Both spouses have input on Major Decisions affecting the business

Continued Co-Ownership Requires Protective Terms

• Contract terms required to protect interests of non-controlling spouse

• These protections include, but are not limited to, the following:

1) Issue new equity and admission of new owners

2) Major business transactions (sale of substantially all assets, merger)

3) Major financings

4) Employ officers and directors and set compensation

Management Liability

Concern to Address

• Duties to Owners Fiduciary Duties

• Duties to Third Parties– Direct claims– Derivative claims– Veil Piercing

Available Options

• Restructure scope of fiduciary duties and indemnifications (gross negligence, willful misconduct)

• Indemnifications

• Insurance

Economic Rights and Responsibilities

Distributions

Capital Calls

Transfers 

Compensation 

Distribution v. Allocation

• Entities taxes as a partnership (including limited liability companies) are known as a “pass-through” or “flow-through” entities for tax purposes

• The entity itself doesn’t pay any income taxes; instead, the profits “pass through” the company to the owners, who report them as income on their personal tax returns

• The share of the profits and losses that each owner reports is the Allocation of profits and losses

• Distributions are when cash is transferred to owners

Phantom Income

Concern to Address

“Phantom income” occurs when pass-through tax entity has taxable income but no distribution to owners

Available Options

Restructure governance documents for mandatory cash distributions to cover taxes

Rely on other assets to satisfy tax obligation

Requires financial analysis to estimate future tax obligations

Distributions

• Generally, governance documents give discretion to make distributions to the company’s management

• No guarantee distributions will be made

Concern to Address

• Timing and Control Over Distributions

Available Options

• Analyze underlying assets: Are In-kind distributionspossible?

• Periodic distributions of cash– Consider timing and permitted

reserves (working capital, future investments, etc.)

Capital Calls and Dilution• Capital Calls occur when company requests or demands that the

owners contribute more money to the company

• Dilution is reduction in the ownership percentage of a company caused by the issuance of new ownership interest

Concern to Address

• Capital call obligations (usually dilution results if owner fails to make capital call)

Available Options

• Restructure governance documents to require owner loans rather than capital calls

• Restructure governance documents; make dilution provisions more equitable

Transfer Restrictions and Exit Strategy

Generally, private companies restrict transfers of ownership interest

Need to consider and plan for exit strategy:

Sale of Business Interest (to outside investors)

• Consider rights of first refusal, tag-along and drag-along rights

• Consider retaining business brokers

Buy-Sell Agreements• Spouses should include the right for either one of them to be able to trigger a buyout at

some point in the future pursuant to a specified valuation process

Buy-Sell Agreements

Structuring a Buy-Sell Agreement • Consider trigger events

• Pricing methodology

– Market test (right of first refusal)

– Formula calculated from financial information

– Opinion of valuation expert

» Consider assumptions/discounts

» Minority shareholder discount

» Illiquidity discount

Compensation

Concerns to Address

• Employee spouse taking out profits as “compensation”

Available Options

• Structure compensation– Caps on compensation and

reimbursable expenses– Structure bonuses to

achieve a win-win for the parties

Intangible Considerations

Goodwill

Business Opportunities 

Intellectual Property

Dispute Resolution

Goodwill

• Personal goodwill (also known as “professional goodwill”) attaches to a particular individual rather than to the business that the individual owns

• Enterprise goodwill (or “business goodwill”) is derived from characteristics specific to a particular business, regardless of who owns or operates it

Business Opportunities

Concerns to Address

• Controlling spouse taking related business opportunities for himself/herself

Available Options

• Non-compete agreements • Enhance or limit fiduciary

duties (the “corporate opportunity doctrine”)

Intellectual Property

Dispute Resolution

• Structure dispute resolution procedures: – Mediation (optional or mandatory)– Arbitration

• Specify duration• Include limits on discovery

– Litigation• Select choice of venue• Jury trial waiver• Injunctive relief; preserve right to obtain temporary restraining order

as needed

• Structure penalties including litigation cost provisions

QUESTIONS?Questions?Questions?

Ladd Hirsch is a business‐oriented, highly successful trial attorney with 30 years experience representing clients in complex business litigation matters and arbitration proceedings. Ladd joined Diamond McCarthy as a partner in 2006. Previously, Ladd was a founding partner of a Dallas‐based litigation boutique. Before starting his own firm, Ladd practiced for almost 20 years with Haynes and Boone, LLP, a full‐service law firm, where Ladd headed up its Business Litigation Practice Group in Dallas.

Laddʹs practice is characterized by his tenacity and creativity in handling the prosecution and defense of significant multi‐party business litigation matters.  Ladd has had extensive experience handling complex business disputes presenting claims for breach of contract, fraud, minority shareholder oppression, violations of fiduciary duties, breach of non‐compete covenants, theft of trade secrets and business defamation. He has litigated claims arising in all of the following industries: manufacturing, commercial lending and financing, construction, computer software, insurance, real estate, beer distribution, retail sales, health care, food service, and video games. Ladd represents both plaintiffs and defendants in business cases under hourly, contingent and hybrid fee arrangements. Ladd has also been retained in a number of matters by other attorneys to serve as an expert witness on the subject of recoverable legal fees.

Ladd has tried cases to judgment in both state and federal courts, including federal courts located in New York and Chicago, and he has argued cases on appeal at both the state and federal levels in Texas.

Ladd HirschPartnerlhirsch@diamondmccarthy.com

214.389.5323

Charles Rubio is a partner based in Diamond McCarthy’s Houston office. He is an experienced business attorney who represents clients in a broad range of corporate and financial transactions as well as commercial disputes. Charles’s practice has a special emphasis on financial restructurings and multi‐party litigation. In addition, he has substantial experience in preparing sophisticated corporate and transactional documents. Prior to joining Diamond McCarthy, Charles was an associate in the Financial Restructuring Group in the New York office of Milbank, Tweed, Hadley and McCloy LLP.

Charles advises clients in all stages of a business life‐cycle. He counsels clients on business formation issues and has worked with entrepreneurs focused on start‐up companies. Charles also works with business borrowers in negotiating and consummating financing facilities and other capital raises. In addition, he handles a wide‐range of commercial disputes including litigation involving contract disputes, breach of fiduciary duties, preference actions and fraudulent transfer claims. Charles represents vendors, landlords, and other parties who have sued or are being sued by bankrupt entities and advises clients during the wind‐down phase of a business life‐cycle. These representations include counseling businesses and management on their rights and responsibilities during insolvency situations and representing clients in distressed asset sales and business restructurings.

Charles is licensed to practice in Texas and New York

Charles M. RubioPartnercrubio@diamondmccarthy.com

713.333.5127

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