There are particular features of divorce and business laws in California which mean that if a marriage breaks down, business owners and their former spouses must consider a range of safeguards and options. This is the first in a two-part series.

This is the first of a two-part feature examining aspects of California divorce law and what happens to the ownership of business assets. Given the issues at stake – including the jobs of those working in affected in businesses – it is easy to see why this is an important topic. The author is Ernest Baello, a partner at Moradi Neufer. The editors are pleased to share this content; the usual editorial disclaimers apply. To comment, email the editors at tom.burroughes@wealthbriefing.com and amanda.cheesley@clearviewpublishing.com.

California’s community property rules put an intense level of scrutiny on any business owner whose marriage dissolves – years of work, financial risk and long-term planning are scrutinized in a unique way.

A business owner may consider the company separate property because it existed before the wedding; however, growth that occurred during the marriage, along with contributions made by either spouse, can influence how the business and its value are treated during a divorce. That prospect can feel especially unsettling when the company supports employees, serves long-standing clients and represents the owner’s primary source of income and future financial security.

Consider a business owner who launched a Los Angeles consulting company eight years ago, two years before getting married. At the time of the wedding, the business operated from a spare bedroom and consisted of little more than the owner’s individual efforts. It now generates seven figures in annual revenue and employs 15 people from an office in Santa Monica.

Now that the marriage is ending, and although the owner’s spouse never worked directly for the company, the spouse managed the household and helped support the family with a part-time job during the company’s difficult early years.

That situation raises difficult questions. How much of the company could the spouse claim? Could the valuation create a buyout obligation that will force the owner to incur substantial debt? Could the divorce lead to a sale? Will discovery expose client lists, contracts, compensation records or other confidential information? What options remain when the spouses never signed a prenuptial agreement?

Business owners may still have several ways to protect the company, preserve control and negotiate a workable resolution. Doing so requires early planning and a clear understanding of how California family law intersects with business ownership, valuation and corporate governance.

Prenuptial and postnuptial agreements offer the strongest advance protection
A properly drafted prenuptial or postnuptial agreement can provide the clearest protection for a privately owned company.

Under California’s Uniform Premarital Agreement Act, prospective spouses may agree in advance about how they will treat a business if the marriage ends. A prenuptial agreement can:
--  Identify the company as one spouse’s separate property; 
--  Establish how the parties will treat growth in the company’s value during the marriage; 
--  Limit claims involving business income or appreciation; 
--  Create a method or formula for valuing the company; and 
--  Address whether the non-owner spouse will receive any role or interest in the business.

California imposes strict requirements on prenuptial agreements. The agreement must be in writing and signed by both parties. Each prospective spouse must fully disclose financial information. The parties must also wait seven days between presentation of the final agreement and its signing.

Business owners should begin this process well before the wedding. Attempting to negotiate or sign an agreement at the last minute can create unnecessary complications and may undermine the careful planning the agreement was intended to accomplish.

Marriage does not necessarily eliminate the opportunity to reach an agreement. Spouses may use a postnuptial agreement to address many of the same business-related issues covered by a prenup.

California courts may examine postnuptial agreements even more closely, however. Both spouses must enter the agreement with complete honesty and transparency. Negotiating while the relationship remains stable may give the parties a better opportunity to exchange information, obtain independent advice and reach terms in good faith.

Waiting often creates the greatest risk. An engaged business owner should consult a family law attorney well before the wedding. An owner who is already married but concerned about the company should explore whether a postnuptial agreement remains a realistic option before distrust or conflict makes productive negotiation more difficult.

Corporate documents can restrict transfers and protect business operations
The documents governing a company can also play an important role in divorce planning.

Depending on the entity, those documents may include a buy-sell agreement, LLC operating agreement, shareholder agreement, corporate bylaws or partnership agreement. Carefully drafted provisions can address what happens when divorce affects an owner’s interest.

A buy-sell agreement establishes rules governing the transfer of an ownership interest. For a closely held company, it may provide valuable protection for the divorcing owner, the company and the other owners.

Potential provisions include:
--  Restrictions on transferring an ownership interest to a non-owner spouse in a divorce; 
--  A mandatory buyout if a spouse acquires a community property interest; 
--  A predetermined valuation process or formula for calculating a buyout; 
--  A right of first refusal allowing the company or its existing owners to purchase an interest before a third party can acquire it; 
--  Voting and management restrictions that prevent a non-owner spouse from participating in daily operations, even when that spouse receives an economic interest; and 
--  Funding mechanisms, including insurance or installment terms, that make a required buyout more manageable.

These provisions can protect business partners as well as the divorcing owner. Co-owners generally do not want a partner’s divorce to disrupt management, change voting control or introduce a new participant into the company.

Corporate agreements have limits, however. They cannot override California family law.

Property acquired during a marriage is generally presumed to be community property regardless of how the parties hold title, and community property is generally divided equally in a divorce. An operating agreement may prevent a spouse from receiving voting shares or assuming a management role, but the agreement cannot unilaterally eliminate a spouse’s claim to the economic value associated with an ownership interest.

Corporate documents therefore work best when coordinated with a carefully drafted prenuptial or postnuptial agreement.

Business owners should regularly review these documents rather than waiting for a divorce to expose weaknesses. An operating or buy-sell agreement drafted years earlier may not account for the company’s current value, ownership structure or transfer risks. Updating those documents generally costs far less than addressing preventable problems after a contested divorce begins.

Divorce discovery can put confidential business information at risk
A divorce involving a privately owned business often requires substantial financial discovery.

A spouse’s attorney may request business and personal tax returns, profit-and-loss statements, client contracts, employee compensation information, ownership records and other documents that could affect the company’s value or the owner’s income.

For many companies, those records contain far more than accounting data. They may reveal customer relationships, pricing strategies, proprietary processes, internal compensation decisions and other information that helps the company compete.

California law recognizes that some business information requires protection. Under the California Uniform Trade Secrets Act, a trade secret includes information that possesses economic value because it is not generally known and that the owner has taken reasonable steps to keep confidential. Depending on the circumstances, trade secrets may include customer lists, pricing structures, proprietary formulas, internal processes and certain marketing strategies.

Business owners and their attorneys can seek several forms of protection during divorce proceedings:
--  A stipulated protective order limiting who may review designated documents and how those documents may be used; 
--  An order sealing portions of the court file that contain trade secrets or proprietary financial information, consistent with California Rules of Court, Rule 2.550; 
--  Confidentiality provisions governing access provided to the spouse’s attorney, financial expert or accountant; and 
--  Reasonable limits on discovery requests that seek information unrelated to the company’s value or the owner’s income.

The need for safeguards becomes particularly important when the other spouse works in the same industry or maintains close relationships with a competitor. In those circumstances, disclosure carries a greater risk of competitive harm, and the owner’s legal strategy should address confidentiality from the beginning of the case.

Business owners can strengthen their position before receiving a discovery request. They should identify which records contain genuinely sensitive information, determine who currently has access and confirm that employee and contractor confidentiality agreements remain current.

Courts considering a request for trade-secret protection may examine whether the company consistently treated the information as confidential. A documented history of access controls, nondisclosure agreements and other protective measures can support the owner’s request to restrict disclosure.

Part Two examines the financial strategies business owners may use to retain control of the company, the steps they can take before a divorce begins and the experience to seek when selecting counsel.

This article provides general information and does not constitute legal advice or create an attorney-client relationship. Business owners should obtain advice based on the specific facts and circumstances of their situations.