COMMERCIAL DIVORCE - THE MOST EXPENSIVE DIVORCE OF ALL?
A business relationship is like a marriage. It involves commitment, trust, honesty, understanding, sacrifice and emotion.
Removing any one of these characteristics may contribute to a breakdown in the relationship.
The wedding day
By the time the big day arrives, most couples have received hours of gratuitous advice from friends and relatives on all aspects of the wedding day, the honeymoon, the home and quite possibly how the planning / scheduling of the children.
If only this were the case for new business ventures. The friends and relatives of most new business owners have little understanding of what is needed to run a small business simply because they are employees, not employers. Their employer pays their tax and superannuation, insures them, trains them and ensures that they have a safe working environment. Everything is provided for them.
A business will fail for a variety of reasons, the two major ones being a lack of capital and an inappropriate choice of business for the business owner, usually due to the business owner failing to have the requisite skills.
Here we introduce the wedding planners (in our case the professional advisers). Before the love birds take a mammoth leap of faith they need to seek advice on what is appropriate whether this is flowers, dress, location and food on the one hand or company, trust, partnership (and collateral documentation) on the other.
Properly planned, the wedding day and the future can proceed with the minimum of stress. The common thread is that all parties intend / expect to contribute (in kind, time, experience, capital and so forth) and to be rewarded for their contributions.
This advice is intended to generally raise some of the issues which may arise when a business relationship breaks down but is not intended to (and does not) cover all of them. Much of the advice relates to business owners who have a company structure but generally there are parallels for all types of business entities.
Contributing factors
Common causes of a commercial break down are:
- unequal or perceived unequal contribution of the business owners to the business, whether time or money;
- a failure by one partner to uphold a promise (or perceived promise);
- a partner is unfaithful;
- the business starts to fail; or
- the partners grow apart, through no fault of any one partner, but to the detriment of all (family pressures including lack of time in the business, the arrival of children, a marriage break down, inability to withstand the pressure).
With the writing on the wall, now is the time to communicate and work on resolving the differences.
The best advice we can provide, is not legal advice but experience. Communicate from the start. Communication impacts upon every relationship.
You must communicate. Everything you say or do, or don't say or don't do, sends a message to others.
So make your communication positive - raise issues, concerns as soon as they make you have a second thought. Ask questions and provide clear truthful answers. Above all listen.
It will only be after negotiation fails, that the business owners need to consider a formal divorce.
Me, myself and I.
We now introduce the trauma cycle.
Divorce creates two types of trauma - mental and financial. The mental trauma associated with a business breakdown can make a rational person do seemingly irrational things, the most common being ?kill the business, no matter what the cost'. This attitude obviously results in a degree of financial trauma, to both the business and each party involved. This in turn causes the parties additional mental trauma.
Financial trauma is simply the result of each party wanting their share of the communal assets. However, everyone has a different perception of what is fair, is theirs, or what they are entitled to.
As negotiations progress, often the emotional temperature rises to an almost unbearable level, so much so that the former love birds cannot understand why they were ever together.
The divorce almanac
Are there any rules that need to be followed? This depends on:
- the structure; and
- what, if any, agreements the business owners put into place with regards to the business structure and their relationship. The presence of well drafted documentation will assist the parties to follow an agreed procedure and thus save money.
Typical documents which may be relevant include:
- the constitution of the company (rights of pre-emption);
- shareholders agreement (rights of pre-emption, options to purchase shares, shot gun clauses);
- unitholders agreement (rights of pre-emption, options to purchase units, shot gun clauses);
- partnership agreement (ability to expel a partner);
- loan agreements / guarantee agreements (liabilities may remain, replace a guarantor);
- buy/sell agreements (exercise a put or call on another party's shares);
- option agreements;
- confidentiality agreements (concerning client list, intellectual property);
- trade restraint agreements (time, industry or geographic restraints);
- employment agreements (notice periods, early termination/liability);
- Trust Deeds;
Whether the parties have or do not have any formal written agreements, certain aspects of the divorce will be governed by a wide variety of legislation including:
- the Corporations Act for companies and some other structures;
- the relevant Partnership Act / Limited Partnership Act;
- the relevant Trustees Act for Trusts;
- ancillary legislation such as the Tax Acts, Privacy Act, Workplace Relations Act (Cth), Criminal Code (or state equivalent), Superannuation Acts;
- other laws which relate to the particular type of business that was being carried out by the business owners or the services provided by the business.
In addition, common law (which is law made by the decisions of the courts) will also be applicable.
Side tracking for a moment, a problem we continually face concerns client DIY company incorporations - lodging an ASIC Form 201 and paying the fee. Yes the client saves money, but following this routine ensures that little, if any, advice is received by the directors.
If the company adopts the replaceable rules, the relevant rules are scattered throughout the 2,000 page Corporations Act like confetti. Given that most advisors don't know all of the 'rules', the business owners hardly stand a chance!
Our point?
The length of the divorce and the trauma that is generated turns on the documentation.
Statistics unconditionally show that the messiest divorces are those where there is no formal documentation that involves more parties than just the business owners. In addition to the ?hired guns' (lawyers and accountants), employees, contractors, creditors, debtors, shareholders and the ATO may all be involved.
Each of these parties will have competing agendas, rights, obligations, duties and liabilities.
Each individual will have different emotions towards the business and each other party.
The rules are set, divorce proceedings have commenced....where to now?
Where divorce is to occur the business owners inevitably have only two options; come to an agreement or dissolve the business entity (that is, liquidate).
Thinking positively, let us consider an agreement between the parties first! Where the business is solvent, there are essentially three options:
- one party will buy out the other;
- the business will be sold and the proceeds divided between the business owners; or
- each of the business owners will walk away with certain assets of the old business with a view to establishing a new business.
Where the business is failing (liabilities exceed or will shortly exceed the business assets) it is more likely that the business owners will wind up the business. At this stage, the only other option is for one of the partners to take on the business, negotiate with each other partner their liability (if any) to contribute to debts / liabilities pre settlement and then for all parties to sign a document evidencing their agreement.
Matters that need to be specifically considered (in no particular order) for these types of agreements are:
- Cancellation of access to buildings, computers / network, accounts;
- Cancellation of exiting partner's business credit cards;
- Cancellation of insurances (for both people / assets);
- Capital Gains Tax;
- Client lists (ensuring the exiting partner does not take them);
- Client poaching/solicitation clauses;
- Exiting partners emails to be archived / deleted;
- Exiting partners emails to return any business assets (laptops, keys, cars);
- Guarantees - procedure to replace / cancel;
- Lease agreements, assignment (if necessary), replacement guarantors;
- Licence to use intellectual property of any exiting partner (if required);
- Loan accounts, agreement of amount / reimbursement;
- Source code of customised software / web site provided to continuing operator;
- Termination of buy / sell agreements if in place;
- Trade restraints of the parties leaving.
Let slip the dogs of war
At this stage, the love birds hate each other. They now talk through their solicitors. There is no hope of an amicable settlement. The business is to be liquidated. Substantial costs are incurred by each party jockeying for position and seeking to have ?their' liquidator appointed.
Upon the appointment of the liquidator, the liquidator will take control of the assets and management of the company. The role and rights of the directors are suspended.
The liquidator investigates and discharges the liabilities of the Company. Liabilities are paid in a set order and business owners normally come at the end of this order. The liquidator investigates any potential claims against the directors and recommends whether they should be pursued. Finally the company is deregistered upon which it ceases to exist.
The costs of the liquidator soon grow and will astonish even the most seasoned entrepreneur. Even if the company had significantly more assets than debts when the liquidation began, the business owners may still walk away with significantly less than they may have done if they had reached a commercial settlement earlier with monies being siphoned away by accountants, lawyers, the liquidator, court, as well as other fees and costs.
Other issues for the married couple
So there are no children of the marriage, but there are some other common 'additional problems' that need to be considered.
New business owners like newly married couples are generally strapped for cash. This often gives rise to two main problems:
- trading whilst insolvent; and
- guarantees (provided by the business owners) are called on.
Trading insolvent
If the business structure is a company, and the company becomes insolvent it must cease trading. Insolvent means that the company is unable to pay all of its debts as and when they become due and payable. Whether a company is insolvent will depend on the circumstances of the particular case.
The relevant section in the Corporations Act is 588G. Penalties for insolvent trading include:
- the director(s) being fined up to AUS$200,000;
- the director(s) being disqualified from managing companies for a period of time; and/or
- the director(s) being ordered to compensate the company for the damage suffered by the insolvent trading.
Guarantees
Financial institutions may require personal guarantees from the business owners (and potentially their family members) to secure business loans.
What happens if one of these guarantees is called on. Typically these type of guarantees are often 'joint and several' which means the creditor can recover the entire guaranteed amount from any one of the guarantors rather than all equally. If one business owner has substantially more assets than the other then this is likely to occur.
Importantly where a liquidator is appointed, guarantees given by the directors / their families remain in place and need to be sorted out by the director.
Business owners' duties
Recently in commercial divorces our most common question has been - ?can I deal with Mr Smith of SmithCorp P/L before the business is wound up. I don't want to lose them as a client?'
The client list of any business is owned by the business (ie the company or the partnership), not by any individual partner or director. Any approach to Mr Smith by a partner in a partnership or a director of a company would be a breach of either sections 40 and 41 of the Partnership Act (WA) or sections 181 to 184 (inclusive) of the Corporations Acts (the duty sections).
Alternatively a business owner decides they would rather ruin all of the goodwill or other value of the business than see any of it go to the other party. Again in a corporate situation this would give rise to a breach of the duty sections of the Corporations Act and in a partnership situation breach the partner's fiduciary duty to the other partner (see Schipp v Cameron, Harrison & ors [1998] NSWSC 997 (9 July 1998)).
Sometimes the breach of a duty can even be a criminal offence - such as taking the client database from the Company.
Our tips for a happy marriage
Before anyone starts a new business we suggest that a client needs to:
- Discuss Everything. Who is to contribute what and what they are to get in return, the possibility of things not working out and what you want to happen in that situation. What decisions involved in running the business can be made by each party and what decisions must be made unanimously? What is to happen on the retirement, untimely death or disablement of one of the business owners? Are any related parties of and/or the business owners to be employed in the business? What are the terms of such employment? If someone doesn't perform their side of the bargain what is to happen?
- Document your Agreement. Once your discussions have taken place (or to facilitate your discussions) have a professional document the agreements you have made with the other business owner(s).
- Know your rights obligations and liabilities. In relation to the business, the other business owners and to third parties (creditors, clients and the ATO).
- Get Advice. Seek advice and help in relation to business planning, taxation, asset protection and insurance issues.
Our tips for professional advisors
When you advise a client on the structure to use for their new business venture, you should advise them of, or advise them to seek advice on, the ramifications of this structure.
For example you tell you client that a partnership of discretionary trusts with a shared corporate trustee is a great structure for their particular business from a taxation and/or asset protection perspective. Sounds like reasonable advice on the face of it, but did you tell your client that the asset held in the trusts will not form part of their estate (to be dealt with under their Will) and therefore they may need legal advice regarding their estate plan? Did you ensure your client had a partnership agreement in place, or advise them to seek advice in relation to a partnership agreement, between the discretionary trusts before they started business? Where there are two driving people behind the business did you suggest they get advice about insurance and agreements in relation to dealing with the untimely death of one of them?
Some of this relates to an advisors professional duty of care to their client and some is just plain good service, but either way if things go wrong with the business just like the business owners you may be kicking yourself for not addressing these issues.