Introduction:
In the space of eighteen months, one of our multi-millionaire clients was economically destroyed by the refusal of his spouse to agree to secure a series of short-term loans. From a net worth of well over ten million dollars, he found himself worth perhaps three hundred thousand dollars and in the midst of a vicious divorce.
When they had married, he had refused to execute a prenuptial agreement despite the advice of counsel, convinced that this marriage, his third, would be the one to last until death. And for ten years it did work, until it did not. She was claiming he was having an affair (he was not) and that he was hiding assets from her (he was not).
Concurrent with his marriage beginning to fail, our client began a series of transactions that required a good deal of capital which he had, and which could double his already sizable wealth. He committed himself to sizable loans which must be secured by his various stock and real estate holdings. He was contractually obligated to provide the capital; it was part of his role in the complex transactions. He had done it many times before he was married and was a bit surprised when the lenders suddenly asked for his wife’s execution of the security documents as well as his. That had not happened before.
But now, married and in a community property state, the banks insisted. He suddenly found out that she had already seen a divorce lawyer who wanted to use this need for her signature for leverage in negotiations as to the coming property settlement. Desperate, our client tried to explain to his wife that failure to provide the capital would ruin them both since they were both obligated to provide it. She did not believe him, and her lawyer told him that he was not permitted to discuss it with her further.
This meant he was in breach of his agreement with third parties who promptly sued him and over the space of less than two years he was both divorced and economically ruined. In a rage, he spent his remaining sums in divorce court, fighting his wife for every dime.
The essence of community property is that it is jointly owned thus every step affecting the property must be agreed to by both husband and wife. This article shall discuss the ramifications of this basic law upon business transactions, what steps can be taken and when to avoid the catastrophe described above.
The Basic Law of Community Property:
Community property law is applicable only in those states termed “community property” states. Nine states within the United States use the community property system to divide marital assets: Arizona, Texas, California, Idaho, Louisiana, Nevada, New Mexico, Washington, and Wisconsin. In Alaska, if both parties agree to make the property community property through a community property agreement or trust, then the property is made community property. Alaska may be considered a voluntary community property state.
Quasi-community property is recognized by some community property states. Quasi-community property is property located outside of a community property state which would be considered community property if located in that state. However, in California, property acquired while married and domiciled in a non-community property state does not become community property just because the married parties move to a community property state.
In a community property state, any asset acquired during a marriage is considered to be community property and hence all assets acquired by any one spouse during marriage belong to both of them equally. Nevertheless, under community property law, certain assets acquired after marriage can be classified as separate property if not commingled.
Community property states normally classify the following as a married couple’s joint property:
Any income received by either spouse during the marriage.
Any real or personal property acquired with income earned during the marriage. This includes vehicles, homes, furniture, appliances, and luxury items.
Any debts acquired during the marriage.
Separate property in a community property state includes:
All property owned by a spouse prior to marriage.
Any property obtained by a spouse after a legal separation.
Any property received as a gift or inheritance during the marriage from a third party such as joint banking accounts.
Any pre-marriage debts.
Note that separate property can transform into community property. This can be done voluntarily by one or both spouses or involuntarily by taking certain actions. As an example, if a spouse owns property before marriage and voluntarily adds the new spouse’s name to the deed, then that property becomes community property. As another example, if community property resources are used to maintain or improve a home or other asset owned separately by one spouse, then the property, at least in part, has a community property interest.
There is also case law that if a spouse devotes sufficient “expert” time to maintaining or improving separate property, then a community property interest is created since his/her community property “earnings” were used to increase the value of the property. Thus, a contractor who spends six months improving a structure that he owns separately can face a claim that the value of his services was community property which is now vested in the property. A stockbroker who spends time assessing and improving a separate stock portfolio may face the same claim.
However, it is important to note that there are no two community property states with exactly the same laws on the subject. For instance, if income from separate property is separate in one state, then in a civil law state, the income from such separate property is community property. Some states have created a newer form of community property, known as community property with right of survivorship. Local counsel is required.
Management of the Community Property:
According to the community property system, each spouse has an undivided one-half interest in the community property. The spouses’ interests are equal, undivided, immediate, and vested. Spouses cannot alter their domicile state merely by choosing to contract in another forum and contractually consenting to the application of that forum’s laws. Where they are actually domiciled will determine the law that applies.
With regard to community property, spouses have a fiduciary duty towards each other. The removal of community property without spousal notice or approval constitutes a breach of such duty. If a spouse conveys or disposes of community property in fraud of the other spouse’s rights, the aggrieved spouse has a right of recourse, first against the property or estate of the disposing spouse and, if that proves to be of no avail, then the aggrieved spouse may pursue the proceeds to extent of his or her community interest into the hands of the party to whom the funds have been conveyed.
Generally, the right of the spouses to contract with each other during their marriage regarding their property rights depends upon statute and varies among the different jurisdictions. The Uniform Marital Property Act abolished restrictions on the power of spouses to enter into property transactions with each other. Spouses have a constitutional right to make an agreement exchanging between themselves the community interest of one spouse in any property for the community interest of the other spouse in other community property. A transaction between spouses, to be valid, must be fair and reasonable and voluntarily and understandingly made. Due to the fiduciary nature of the relationship, full disclosure, and ample time to consider the ramifications is required are necessary. It is wise to have independent legal counsel represent each party.
Some statutes permit transmutation of property if it is made by an express declaration which contains language expressly stating that the characterization or ownership of property is being changed. The Uniform Marital Property Act provides that spouses may reclassify their property by gift or by a marital property agreement. California allows such transmutation agreements, subject to strict requirements of disclosure and fairness.
In many states, in the absence of special circumstances, a husband has the exclusive right to represent the community in litigation involving community property. However, the wife sometimes may maintain an action to avoid a transfer of community property made by the husband in violation of statutory restrictions on his power of disposition. Moreover, the wife may sue to recover community property when, for reasons of public policy, the husband could not maintain the action, and when the spouses’ interests are antagonistic. Furthermore, a judgment rendered against the husband concerning the title to community real property is not binding on the wife, when the judgment was obtained in fraud of her interest, and she was not named as a party. See In re Norton, 180 B.R. 168 (E.D. Tex. 1995).
In California, spouses have joint control of community property with concurrent rights of management. However, most third parties require written consent of both spouses in any transaction involving community property to avoid the entire issue of whether a particular spouse had the power to commit the community. Refusal of one spouse to consent normally will stop the transaction from occurring.
Neither spouse can force the other spouse to consent to or waive rights as to any transaction.
The Effect on Business Transactions:
Below is a typical requirement for the transfer of membership interest when the interest is community property:
I, [__________________], certify and declare that:
1. I am the spouse of _________________ (“Spouse”), who is the holder of ____0% of the Membership Interests of ____________ LLC, a California limited liability company (“Company”).
2. Subject to that certain Gift Letter with attached Membership Interest Assignment and Assumption Agreement effective as of January 1, __________, my Spouse has agreed to transfer all ___% of his Membership Interest in the Company to ____________ (the “Gift Letter”).
3. I have read the Gift Letter, know its contents, and am aware of my right to be represented by independent counsel of my own choosing to explain the meaning and legal consequences of the Gift Letter.
4. I agree to be bound by and accept my rights under the provisions of the Gift Letter in respect to any community property or other interests I may have in my Spouse’s Membership Interest in the Company.
5. I grant my Spouse an irrevocable special power of attorney, which is coupled with the interest of my Spouse and me under the Gift Letter, to deal with the subject matter of the Gift Letter and to modify, amend, and/or add to the Gift Letter without further signature, acknowledgment, agreement, or consent on my part.
6. I agree not to take any action at any time which might interfere with or hinder the operation of the Company in connection with the Gift Letter and any interest or rights now by me or my Spouse arising from or related to my Spouse’s Membership Interest in the Company.
___________________________
Spouse of __________________
Several things should be apparent from the example:
Consent is needed of the spouse. Without, nothing goes forward.
She/he has the right to be represented by counsel and must either so consult or recite she does not want to take advantage of that right.
She must waive rights to object in the future and, ideally, give a power of attorney to spouse to handle any other documents required.
Assuming those requirements are met, the process can go forward. It is vital for any businessman or woman who might require such consent to realize the scope of what is required. If there is trouble in the marriage or if the spouse obtains advice from counsel who is unreasonable, the deal is likely dead.
As one client put it well when discussing his three-person corporation, “We are not three shareholders. We are six shareholders and we had better all remember that.”
Solutions:
Forethought and planning are the keys to avoiding problems. The worst thing you can do is assume such consent will always be forthcoming. While all are still on friendly terms, certain proactive steps can be taken.
A prenuptial agreement that separates out separate property and gives one spouse sole control of it is by far the best solution. They are now common in California. One can create a postnuptial agreement as well but the requirements to achieve one, with the added fiduciary duty to a spouse, can be significant.
A power of attorney from the spouse as to certain business assets can achieve the same control without the need for a full prenuptial agreement. Before it can be relied upon, the spouse should have separate counsel or waive it.
Certain agreements within companies, such as buy and sell agreements, can have provisions that require the spouse to consent in advance to certain actions. Again, separate counsel may be necessary.
At the least clear and honest communication is essential. If one spouse trusts another, such consent after such communication is usually possible. Do NOT assume it will always be forthcoming. Do not commit yourself until you are sure your spouse confirms her or his position on the matter.
Conclusion:
In marriages when things go well problems arising may seem remote. But the essence of a good businessperson is to anticipate problems and community control of property is one aspect that should be considered. It is a difficult discussion to have with a spouse. Immediately the suspicion will arise that something is “wrong” and why else would someone bring that issue up? However, each owner of a business truly has a duty to the company to make sure that decisions do not suddenly founder due to marriage issues that one particular owner may have. And there is no better time to consider the issue and take steps to resolve it than now.