A Long and Winding Road
By William D. Bishop
Bishop Law Offices, P.C.
Over the last four years, I have had the opportunity to be involved in what Frank Pankow has termed “The Mother Of All Rueschenberg Cases.” The cast of characters included myself on behalf of Husband, Mervyn Braude on behalf of Wife, Husband’s expert Frank Pankow, and Wife’s expert Lynton Kotzin. The amount at issue in this case was substantial, which meant that there were few restrictions to the number of legal and financial issues explored.
Fortunately, my opposing counsel in this case, “Charming Mervyn,” was the ultimate professional. If one is going to spend over four years in a case, one can only hope to have opposing counsel who is flexible, cooperative, and entertaining to litigate with.
The major focus of this article is to explore apportionment issues, i.e., the community’s claim to a portion of the increase in value to a sole and separate business. However, any such litigation involves valuation issues as well.
In this case, I represented the sole and separate business owner; however, it is not my intent in this article to take a position one way or the other, especially in light of the fact that my next client may be the non-owner spouse.
I. UTILIZATION OF EXPERT WITNESSES.
There is little doubt that qualified experts are essential in valuation and apportionment cases. If you are litigating a case involving the assessment and apportionment of a community interest in the increased value of a sole and separate business, there is a good chance that you are going to spend a lot of time with your expert over many months or even years.
There are of course many moving parts to a community property business valuation case. However, when the community makes a claim to the increased value of a sole and separate business, the issues increase exponentially. To begin with, you are now dealing with at least two valuations, and possibly more if there exists a dispute regarding the end valuation date. Once the increase in value is determined, the expert must address several apportionment methodologies and potential hybrids of such methodologies.
As Phoenix family law attorneys, it is sometimes easy to defer to our experts to simply tell us the bottom line. However, the best experts equally rely upon the attorney to challenge their opinions, especially when the expert retained by the other party will be doing just that. An attorney who takes on an apportionment case must obtain an intricate knowledge of both the case law and the numerous valuation and apportionment methodologies due to the substantial interplay of legal and valuation concepts. The resolution of each and every issue and sub-issue may have a substantial impact upon whether the community has a claim to a portion of the increase in value, and if so, the amount to which the community may be entitled.
II. USE OF A SPECIAL MASTER.
Similar to the Rueschenberg case, the parties stipulated to the appointment of a Special Master in our case. I highly recommend the use of a Special Master in an apportionment case. This is not to say that our judges are not capable of assessing these types of cases. However, as we know, it is often difficult to obtain the trial time necessary to present a very complex case in the time allotted. In our case, Mervyn and I initially felt that two days would be sufficient to address the valuation and apportionment issues. Once we hit day four, we realized we “slightly” misjudged the time that was necessary.
Another advantage of using a Special Master is that we were able to present our case in phases. Each phase allowed for updated reports by the experts, which in turn helped establish what the remaining disputes were. In light of the numerous issues that were litigated, I cannot imagine how a trial judge could sift through the various issues and come to a numerical conclusion unless the trial judge simply selected one of the expert’s opinions on each and every issue. If a judge decided that one of the experts was more credible on one specific issue, and the other expert was more credible on another issue, it is likely that no corresponding calculation would have been submitted that fit such scenario. Unless the judge was a valuation expert, follow up calculations would clearly be necessary. In our case, we agreed that the experts would be able to submit supplemental reports based upon the Special Master’s initial determinations on specific issues. The ultimate goal was that once the Special Master eventually ruled upon such issues, the two experts’ ultimate calculations “should” be identical.
Another consideration to keep in mind is your professional liability insurance premiums. By utilizing a Special Master in such a complex case, there is a better chance of filling in the gaps in the event that new sub-issues arise in the middle of trial.
Fortunately, in our case, we had a Special Master who was very accommodating and knowledgeable, and a trial judge who was flexible with providing continuances on the inactive calendar as we made our way down the long and winding road.
III. VALUATION ISSUES.
If a company has no goodwill value beyond its parts, an asset-based approach is generally applied (i.e., the value is the net sum of its parts). If a company is the type that can be compared to similar sales in the marketplace, a market approach may be appropriate. However, for a company that appears to have goodwill value beyond its net assets, but is the type of company that involves limited or no comparable sales, an income approach is generally relied upon. The experts in our case both concluded that an income-based valuation was appropriate as a result of limited sales transactions of companies that could be compared to the company at issue.
A. Valuation Date.
The valuation date for purposes of identifying the increase in value to a business may be an important issue. The initial valuation date is usually obvious, i.e., the date of marriage if the business was started before marriage (or the date that the sole and separate business interests were inherited, or were gifted to the business owner as in our case). The date selected for the end valuation can be more problematic.
In Sample v. Sample, 152 Ariz. 239, 731 P.2d 604, 607 (App. 1986), the Court of Appeals explained that the valuation date is to be “dictated by largely pragmatic considerations,” and that “the equitableness of the result must stand the test of fairness on review.” In other words, the trial court is not bound by a specific date for purposes of valuing a business but should determine a date that is equitable under the circumstances.
Although such case holding makes common sense, it also leads to various complications, including the submission of more than one valuation based upon different valuation dates. If there are competing experts, such may involve separate valuations submitted as to each valuation date at issue.
In our case, the business at hand realized a substantial decrease in profits during the litigation, which affected the overall value of the company. It was for the most part uncontested that the decrease in profits was a result of Arizona’s economy, industry conditions and other factors outside of the owner’s control. Under such circumstances, it is arguably unfair to penalize the sole and separate owner for the decrease in value that took place after the termination of the community. Accordingly, it made sense that a later valuation date be applied. If changes in the company during the litigation are ongoing, it is possible that several valuation updates may be provided until the company stabilizes.
The converse argument could of course apply. A valuation after the termination of the community may be desirable to the non-owner spouse if the value of the company has increased as a result of the economy and reasons other than the post-service efforts of the owner spouse.
B. Fair Value versus Fair Market Value.
Whether fair value or fair market value is adopted is a significant issue. Most experts provide such valuations in the alternative, at least with regard to companies that are capable of being sold. Arizona has no published case authorities that specify when one valuation premise should be adopted over the other.
If fair market value is adopted, marketability and/or minority discounts should be applied. These discounts can be very substantial, often leading to a 30% to 70% reduction in the overall value (or even more depending upon the circumstances).
In the case at hand, we made the argument that a marketability discount should apply because the company was closely-held, which would lead to marketability problems with finding a qualified hypothetical investor who would be willing to purchase the owner’s interests in the business. Because my client was a minority owner, we also argued that his interest was non-controlling, and that a potential investor would desire a further minority discount.
Wife of course argued that fair value should be adopted (i.e., without valuation discounts) for various reasons, including the fact that the business was not being marketed for sale, and there was no imminent sale. Wife also contended that the application of such combined discounts would lead to a result that was little more than the value of the hard assets (thus nullifying any good will value). In the alternative, Wife argued that if a discount was provided, only a marketability discount should apply, and not a minority discount, for the reason that such discounts would be cumulative and based upon the same circumstances.
In this case, one can see some overlap between a marketability discount and a minority discount. It is possible that a marketability discount may be appropriate because the owner has a minority interest, and that because of the lack of control, it will be difficult to market such interest. These same facts of course give rise to an argument that a minority discount is appropriate because it is not a control interest, and an investor would want a discount in light of such lack of control. In that case, the Court may be inclined to apply only a marketability discount in order to avoid providing separate discounts based upon the same circumstances.
There is limited discussion in Arizona case law regarding what premise of value (i.e., fair value versus fair market value) is appropriate, other than to apply a method that will achieve “substantial justice.” There does appear to be a disconnect to the extent that fair value is generally applied to professional practices (such as law firms), which are not capable of being sold. An argument can certainly be made that it is unfair that a company that is capable of being sold may be eligible for such discounts, while a company that cannot be sold is not.
C. Capitalization Rates.
One of the most significant issues litigated pursuant to income-based valuation cases is the appropriate capitalization rate (“cap rate”).
The cap rate is the number used to convert a benefit stream (e.g., income stream) into a company’s value. The cap rate equals the discount rate (the yield necessary to attract investors to a particular investment given the risks associated with the investment) less the expected growth of the company (generally 2 – 3% as a rule of thumb). The determination of the appropriate cap rate must assess the risk associated with a company’s historical income stream recurring in the future. The greater the risk, the less an investor will be willing to pay. Valuation experts look to various publications to determine an appropriate cap rate. In simple terms, the greater the risk associated with the company, the higher the cap rate, and the lower the value.
The importance of cap rates can be exponential in a sole and separate business apportionment case because cap rates are being applied to both the beginning and end values. For example, if the cap rate applied to the initial valuation (generally the date of marriage) is too high, the starting value would be artificially low. If the cap rate applied to the end valuation is too low, the end value would be artificially high. Under this scenario, the increase in value during marriage would be inflated on both ends. The reverse scenario could of course apply, i.e., an artificially low cap rate applied to the beginning valuation and an artificially high cap rate applied to the ending valuation could dramatically reduce the amount subject to the community’s claim.
Litigation involving the appropriate cap rate can be substantial in light of the impact that cap rates have on the overall value (and the resulting increase in value during the marriage, if any). Even a few percentage points can have a substantial impact.
When litigating the issue of the appropriate cap rate, the attorney who is arguing a higher cap rate (i.e., a lower value) should be prepared to present evidence regarding the risks associated with the business, and the possibility that the historic stream of income may not occur in the future. The attorney who is arguing a lower cap rate (i.e., a higher value) should of course be prepared to present the opposite, i.e., that the company is very stable, and that there is a high probability that the company will continue to realize equal or greater profits in the future.
D. Operating Assets Versus Excess Cash and Other Non-Operating Assets.
Another major issue in our case involved a determination of how the funds in the company accounts, and the company investments should be treated.
For purposes of income-based valuations, the cash on hand that is necessary to continue to operate the business is already included in the overall valuation of the company. Cash that is necessary to generate such income falls within the category of “operating assets” (i.e., necessary for the ongoing operations of the business). Operating assets also include equipment, inventory, etc. that are necessary to produce the income upon which the valuation is based. Accordingly, it is improper to add the value of operating assets to an income-based valuation.
Non-operating assets, on the other hand, are those assets that are not necessary to produce the income upon which the valuation is based. Our case involved substantial litigation over what portion of the cash in the company accounts was necessary to generate the income upon which the valuation was based, versus the amount of cash that could arguably be distributed to the shareholders without affecting the operations of the business. The cash that is not necessary to operate the business is called “excess cash.” Because excess cash is not necessary to operate the business, such is generally added to the value of the business after capitalizing the stream of income.
In our case, the company had other real property investments. Because the company did not invest in real estate as part of its operations, these were passive investments. Passive investments constitute additional non-operating assets, and would be added to the value of the business.
Although these principles are standard in a valuation case, an apportionment case may change such analysis. An interesting twist in our case involved Wife’s argument that the excess cash and other non-operating assets should not be added to the value of the company, but rather treated as undistributed assets which still needed to be divided. Such issue is addressed in more detail in Section V.F. below.
IV. APPORTIONMENT CASE LAW.
Once the Court determines the increase in value to a sole and separate business during the marriage, the Court must determine what portion of such increase, if any, constitutes sole and separate property, and what portion of such increase, if any, constitutes community property. The general concept involved is that the sole and separate owner should retain any portion of the increase in value that was not created pursuant to community efforts, and that the community should receive any portion of the increase in value attributable to community efforts. As can be seen by the alternate apportionment methods and numerous sub-issues described below, this is easier said than done.
The apportionment litigation stage can be much more subjective than the business valuation stage. The business valuation expert has numerous publications, sources, etc. to rely upon in order to substantiate his / her valuation. That is not the case once we enter the apportionment part of the case. To my knowledge, there are no authoritative publications on how to apportion the increase in the value of a sole and separate business. Although Arizona has a few published court cases, including the 2008 Rueschenberg decision, such cases often give rise to more questions than answers.
A. Cockrill v. Cockrill.
The seminal “modern” business apportionment case is Cockrill v. Cockrill, 124 Ariz. 50,
601 P.2d 1334 (1979). In Cockrill, the Supreme Court of Arizona addressed two non-exclusive methods that may be applied to apportion the increase in value to a business between the sole and separate owner and the community, i.e., the Fair Compensation Method, and the Fair Return Method. Although cases issued after Cockrill have changed the landscape considerably, the Fair Compensation Method and the Fair Return Method are still addressed by experts as two of the possible methods for the Court to adopt. The main conclusion that resonates from Cockrill is that the trial court has substantial discretion to adopt an apportionment method “that will achieve substantial justice between the parties.” Accordingly, any attempt to argue that one method is predominant in all cases is unsupportable.
The Fair Compensation Method addresses whether the community received reasonable compensation during the marriage. If the owner spouse did not receive reasonable compensation for his or her services, the community would have a claim to a portion of the increase in value up to the amount that the community should have received. This method does not appear to be a true apportionment of the increase in value as it only measures whether the community received reasonable compensation for its efforts, and thus any remaining increase in value would automatically revert to the sole and separate business owner. It goes without saying that theFair Compensation Method is generally favorable to the sole and separate business owner. Although still a valid argument, no Arizona published opinions issued subsequent to Cockrill have adopted the Fair Compensation Method as to the determinative approach.
The Fair Return Method is essentially the flip side of the Fair Compensation Method. Pursuant to theFair Return Method, the sole and separate business owner is provided a “reasonable rate of return” pursuant to his or her sole and separate ownership interest in light of the associated risk (i.e., the higher the risk, the higher the rate of return). Once a rate of return is apportioned to the sole and separate owner, the entire remaining sum of the increase in value is attributed to the community. This method is generally favorable to the community depending upon the selected rate of return. One of the most significant issues that is litigated pursuant to a Fair Return Method approach is the rate of return to apply. Even small adjustments to the rate of return will have a major impact on the overall apportionment as applied over a long term marriage. Similar to the Fair Compensation Method, no published opinions issued subsequent toCockrill have adopted the Fair Return Method as the determinative approach.
B. Rowe v. Rowe / Roden v. Roden.
The next major published opinions to address the apportionment issues were Rowe v. Rowe, 154 Ariz. 616, 744 P.2d 717 (Ct. App. 1987), and then ten years later Roden v. Roden, 190 Ariz. 407, 949 P.2d 67 (Ct. App. 1997). In both cases, the Courts did not adopt either a Fair Compensationor Fair Return method, but rather apportioned the increase in value and earnings received by the community based upon community efforts versus other external factors. The Courts then determined whether the community was already compensated for its share of the increase in value as a result of its receipt of compensation during the marriage. In other words, the Courts found that a portion of the compensation received by the community was a result of external factors rather than community efforts, and that if the community had already received its fair share of the increase in value as a result of its receipt of the sole and separate owner’s share of the earnings, the community would not be entitled to further compensation. As noted in Rowe,
The court admitted that it could not precisely quantify the overlapping contributions. It did determine that at least two-thirds of the responsibility for the post-marital growth of JRA was due to the community contribution and that at least one-quarter of the growth was attributable to a return on the inherent value of the pre-marital company. The court concluded that a fair ratio to apply would be three-fourths/one fourth. Because the community had received, through distribution and pension and profit-plan contributions, more than 75% of the sum of net distributable earnings and (assumed) goodwill, the court held that the community had been fairly compensated for all of its contributions to the growth of JRA. Rowe, 154 Ariz. at 620, 744 P.2d at 721.
The Roden Court reached a similar conclusion:
Here, the trial court found that the increase in value of Desert Subway, Inc., which resulted from community efforts, was offset by the amount of compensation – community property – that each party received during the marriage. Roden, 190 Ariz. at 411, 949 P.2d at 721.
Many practitioners misunderstand Rowe and Roden as applying the Fair Compensation Method, i.e., if the community received reasonable compensation, it is not entitled to further funds. However, these decisions were not based upon such method. Rather, the Courts concluded that the community essentially received excess compensation (the portion that the sole and separate owner would be entitled to pursuant to an apportionment), and that this excess compensation adequately compensated the community for its share of the increase in value to the business during the marriage.
C. Rueschenberg v. Rueschenberg.
And then along came Rueschenberg v. Rueschenberg, 219 Ariz. 249, 196 P.3d 852 (Ct. App. 2008). The Rueschenberg Court adopted the Special Master’s rulings, which were affirmed by the trial court. Rueschenberg then went on to provide a history lesson regarding apportionment cases throughout the years, and went to great lengths to dispel the husband’s arguments that the community had already been adequately compensated for the community’s efforts, and that the trial court did not have the discretion to award the wife anything further.
In short, Rueschenberg addressed four general methods of apportionment:
- (1) the Fair Compensation Method addressed by Cockrill;
- (2) the Fair Return Method addressed by Cockrill;
- (3) the apportionment methodology applied in Rowe and Roden;
- (4) the hybrid methodology that was applied by the Special Master and adopted by theRueschenberg trial court.
1. Affirmation of Trial Court’s Rulings (Hybrid Method).
The Special Master’s apportionment rulings in Rueschenberg took the apportionment analysis to a new level by applying a hybrid of the Fair Return Method addressed in Cockrill, and an apportionment type analysis as addressed in Rowe and Roden. The Special Master first applied an annual fair rate of return from the initial valuation date, which was apportioned to the business owner as his sole and separate property. The analysis did not end there, however. Rather, the Special Master applied a Rowe / Roden type of apportionment analysis to the remaining increase in value (the Special Master determined that two-thirds of the remaining increase in value was a result of community efforts, and one-third of the remaining increase in value was a result of inherent or external factors that should be retained by the sole and separate business owner). Id., 196 P.3d at 854. This analysis makes sense to the extent that it may be unjust to merely assume that anything above and beyond a fair rate of return is based upon community efforts. Rather, the Special Master apportioned the “left overs” pursuant to a determination of the percentage of increase in value attributed to community efforts versus other inherent or external factors. The Special Master, however, did not completely adopt a Rowe / Roden approach; the excess income received by the community was not set off against the community’s share of the increase in value (this issue will be further explored later in this article).
The hybrid methodology adopted by the Special Master in Rueschenberg is arguably a reasonable compromise between the different methodologies. It benefitted the owner-husband to the extent that the increase in value above and beyond a fair rate of return was not apportioned entirely to the community. It benefitted the community to the extent that its receipt of “excess compensation” (the sole and separate owners share of the income that was not derived from community efforts) was not offset against the increase in value.
The Rueschenberg Court, in its decision, spent little time addressing the trial court’s adoption of the Special Master’s rulings, and simply held that the rulings were within the discretion of the Court. Instead, most of the Rueschenberg opinion addresses the husband’s various arguments that the trial court’s rulings were erroneous, and that the community had no claim to a portion of the increase in value of the business as a result of the compensation it had already received during the marriage. The bottom line holding by the Rueschenberg Court is that the trial court “is not bound by any one method [of apportionment], but may select whichever will achieve substantial justice between the parties.” Id., 196 P.3d at 858 (citing Cockrill v. Cockrill, 124 Ariz. 50, 602 P.2d 1334 (1979)).
2. Rueschenberg’s explanation of apportionment methodologies.
After the Rueschenberg Court affirmed the trial court’s adoption of the Special Master’s methodology, the Court turned its attention to the husband’s arguments that the trial court was incorrect.
The first major issue regarded the husband’s argument that the community was not entitled to share in both the profits and increase in value to a sole and separate business. Id., 196 P.3d at 855. In short, the Rueschenberg Court rejected the husband’s arguments and held that the community is entitled to a portion of both the profits and increase in value attributable to community efforts “to the extent substantial justice requires it.” Id., 196 P.3d at 856-57. Although the ruling leaves open the possibility that the courts may continue to apply the Fair Compensation Method as previously addressed, the language could be interpreted to limit such possibility.
The next related issue addressed by the Rueschenberg Court regarded the husband’s argument that if the community received a fair salary for the community’s labor, the inquiry should end and no further apportionment is permitted. Id., 196 P.3d at 857. In rejecting the husband’s argument, the Rueschenberg Court explained that Cockrill “rejected any requirement that the trial court follow one method of apportionment over another,” and that “[t]he clear distinction from Cockrill is that the method of apportionment applied must ’achieve substantial justice between the parties.’” Id., 196 P.3d at 858.
In response to the husband’s argument that Roden v. Roden, 190 Ariz. 407, 949 P.2d 68 (Ct. App. 1997), supported his position that adequate compensation to the community precluded further apportionment of the increased value of a business, the Rueschenberg Court explained that the holding in Roden does not stand for such proposition. Rather, in the Roden case, “the trial court determined that ’the increase in value of [the separate business], which resulted from community efforts was offset by the amount of compensation – community property – that each party received during the marriage.” Id., 196 P.3d at 859. In other words, the inquiry inRoden was not whether the community received fair compensation, but rather whether the community received excess compensation (a portion of the sole and separate owner’s share of the compensation) in a sufficient amount to offset the community’s share of the increase in value.
The Rueschenberg Court explained that its offset analysis was also applied in Rowe v. Rowe, 154 Ariz. 616, 744 P.2d 717 (Ct. App. 1987). In that case, the trial court applied a three-fourths / one-fourth apportionment between the community efforts and sole and separate portion of the increase. Id., 196 P.3d at 861. Nevertheless, the Rowe Court found that the entire increase was sole and separate property because:
[T]he community had received, through distribution and pension and profit-plan contributions, more than 75% of the sum of net distributable earnings and (assumed) goodwill.” Id. Accordingly, there was no error in the trial court’s conclusion that ’the community had been fairly compensated for all of its contributions to the growth of [a separate business]. Id., 196 P.3d at 861.
In applying the Rowe / Roden methodology to the facts at hand, the Rueschenberg Court went on to state that:
If, as a result of its receipt of the funds, the community already had received more than its proportionate share of the total profits and increase in DMM, and the trial court used the reasonable rate of return method to award the community additional monies, that may violate the fundamental rule from Cockrill to apportion the increase equitably.
Id. (emphasis added). The Rueschenberg Court, however, rejected the husband’s argument that the community had been adequately compensated for the increase in value based upon procedural deficiencies:
[N]o request was made of the trial court to determine the amount of the net distributable earnings paid to the community. Neither was there a request to determine that the same two-thirds / one-third ratio as to value (goodwill) applied to net earnings. Id.
The Rueschenberg Court thus held that Mr. Rueschenberg was unable to make such offset argument on appeal, and explained:
To prevail on this argument, Husband would be required to show at a minimum that the community received more than its pro rata share of the combined total of net distributable earnings and increase in goodwill. Equally, and conversely, he would have to show that he received less than his pro rata share of the earnings as separate property. As pointed out above, the trial court was never asked to determine, and did not determine, the amount of net distributable earnings (income less salary and other expenses) generated during marriage. Because of this, we are unable to determine the combined total of net distributable earnings and increase in value. Thus, there is no factual basis on which to assert error as there is no total figure to which the two-thirds / one-third ratio can be applied to determine – as the court did in Rowe – whether the community has already received its proportionate share of the total and no further moneys were owed.Id. at 862.
In making its determination that the husband did not properly raise his arguments or present adequate evidence, the Rueschenberg Court seems to have raised the bar above and beyond what was reflected in Rowe and Roden. It is clear from the Rueschenberg opinion that the Court was provided information regarding the total compensation received by the community. An apportionment analysis was presented, and rulings were issued. Whether the husband argued that the community was adequately compensated, versus arguing that the community was overcompensated and that such overcompensation should be offset against the increase in value, is arguably a distinction without a difference. Such analysis is further convoluted by the unworkable definition of “net distributable earnings” and footnote 9 of the opinion, which essentially states that the issues of co-mingling, waiver or estoppel may preclude an offset of excess compensation paid to the community against the community’s share in the increase in value.
The Rueschenberg Court could have merely stopped with its holding that the trial court exercised proper discretion by adopting the Special Master’s methodology. While Rueschenbergprovides a certain amount of clarity regarding the various methodologies that may be applied in an apportionment case, it also creates further confusion on many fronts.
V. LITIGATING THE APPORTIONMENT CASE.
After hearing the evidence in our case, the Special Master issued a ruling that an apportionment analysis would be entered based upon the Rueschenberg opinion. Thus, a strict application of the Fair Compensation Method or Fair Return Method were no longer at issue. Therefore, attention was turned to the Special Master’s hybrid method and the Rowe / Roden apportionment methodology as described in the Rueschenberg opinion.
A. Rate of Return Litigation.
As noted previously, if the approach applied by the Special Master and adopted by the trial court in Rueschenberg is selected, the sole and separate owner is first entitled to a fair rate of return on his investment from the date of marriage or receipt of the interests (compounded annually) prior to an apportionment of the remaining increase in value.
It goes without saying that the application of a high or low rate of return can have a material impact upon whether the community is entitled to any of the increase in the value of a business and, if so, how much. Accordingly, it is always a good idea to obtain a second opinion – even if the clients agree to a mutual expert.
In our case, there was a substantial difference (almost 50%) in the rates of return applied by the opposing experts. Such differential was not only based upon varying publications, but more so by differing philosophies regarding what a fair rate of return in an apportionment analysis entails.
In our case, it was Husband’s argument that the rate of return must be synonymous with the discount rate applied pursuant to the valuation analysis. In other words, we argued that the sole and separate owner should receive a comparable rate of return that a third party investor would require to invest in the company based upon the applicable risk. The Rueschenberg opinion notes the relationship between the desired rate of return and the capitalization rate in its footnote 2. Such relationship is also addressed in footnote 3 of the recent case Walsh v. Walsh, 1 CA-CV 11-0269 (App. Div. 1 2012).
Wife, on the other hand, essentially contended that a fair rate of return as applied to an apportionment analysis is different than the expected return that an investor would require for purposes of determining a discount rate. Wife submitted data that Husband’s requested rate of return far exceeded the average returns that investors realized pursuant to publicly-traded investments, including investments in the subject industry as a whole. The parties disputed whether such average returns were relevant, as they were based upon publicly-held companies, as opposed to a return that an investor would require prior to investing in a small closely-held company. Wife’s rate of return applied a buildup method, similar to what was done by Husband’s expert, but the differential applied to the risk factors was substantial.
It was also Husband’s argument that Wife’s lower rate of return was improper because it was based upon the company’s established success, as opposed to a rate of return based upon the initial investment. In Cockrill, the supreme court explained:
Finally, the trial court may simply allocate to the separate property a reasonable rate of return on the original capital investment. Cockrill v. Cockrill, 601 P.2d at 1338 (emphasis added).
The Rueschenberg Court offered similar language: “It arrived at this figure by giving what is considered to be a fair rate of return on the original investment of $163,166”. Id., 196 P.3d at 854 (emphasis added).
Other than the limited references set forth above, case law regarding what constitutes a fair rate of return pursuant to an apportionment analysis is sparse.
An additional and interesting argument by Wife was that utilizing the capitalization rate as the rate of return is conceptually incorrect because small businesses typically generate most of their profits in the form of excess compensation, dividends, distributions and other benefits paid to the owners. As such, the owners do not reinvest such profits into the company, which effects the company’s ability to grow and realize capital appreciation. The contrary argument to such position is that it does not matter how the community is compensated (whether it is received as excess income or by having a claim to the increase in value), so long as the community has received its combined share of both.
The argument that a lower rate of return should be applied to a longer term marriage may be persuasive. For example, should an owner in an apportionment case experience the same rate of return that a third party investor would require in order to make the investment? The reason that the third party investor requires a high rate of return is because of the risk. Simply because the investor “requires” a certain rate of return does not mean he or she will actually receive it. If the rate of return equals the discount rate, the owner would essentially be guaranteed that rate of return regardless of risk up to 100% of the increase in value. While on one hand the business owner should arguably be able to realize a rate of return synonymous with what a third party investor would expect, the application of a rate of return synonymous with the discount rate over a long period of time may virtually eliminate the community’s claim to any increase in the value of the business. The rate of return applied in Rueschenberg (a five year marriage) was 25%, which still allowed for some remaining increase in value to be apportioned. However, if that rate of return is applied over a longer marriage, it may be relatively impossible for a company to experience an increase in value that exceeds such rate of return year after year.
B. Apportionment Litigation.
Under either the Special Master’s hybrid analysis in Rueschenberg, or a Rowe / Roden analysis, an apportionment is conducted – i.e., what portion of the increase in value is attributed to community efforts, and what portion is attributed to other factors? If the Special Master’s methodology is adopted, the apportionment is applied after the sole and separate owner is attributed a fair rate of return. If a Rowe / Roden analysis applies, no rate of return is applied prior to the apportionment; however, an offsetting analysis takes place after the apportionment is concluded, as previously discussed.
In Rueschenberg, the Court referenced that at least a portion of the increase in value was attributed to factors other than community efforts. According to the Rueschenberg Court, the husband presented evidence “that the company’s increased value was due to an increase in manufacturer marketing and sales assistance, increased customer acceptance of the products, increased research and development by manufacturers, natural population growth in the market area, and other DMM sales personnel expanding the market.” Rueschenberg, 196 P.3d at 854.Based upon such evidence, as noted previously, the Special Master determined that two-thirds of the increase was attributable to the community, and one-third was attributable to other factors.
The issue of which apportionment analysis to apply falls within the wide discretion of the trier of fact, and is clearly not subject to precise mathematical calculations. Although one can certainly attempt to present an expert’s opinion regarding apportionment, it is questionable whether a CPA or other expert has any greater ability to reach an apportionment conclusion than the trier of fact.
In our case, the company was started by Husband’s father. The father gifted separate 33% interests to each of his three children (including Husband), while retaining 1% of the stock. Although the father had limited stock ownership, he secured and maintained the relationship with the company’s main client, served as the company’s Chief Executive Officer, and made or was intimately involved in the most important company decisions. Husband served as president of the company, while his siblings both served as vice presidents.
In order to minimize the community claim, it was of course Husband’s goal to establish that the increase in the value of the business was due primarily to inherent or external factors (factors that contributed to growth other than Husband’s community efforts). Husband submitted evidence that the increase in the company’s value first and foremost was a result of Husband’s father, his connections, his knowledge of the industry, and his continued relationship with the company’s main client. Husband also contended that various other persons had a major role in the success of the company, including Husband’s siblings, and the company’s Chief Financial Officer. In the same regard, Husband contended that although he was the president of the company, he was essentially second in command, and that his father was still the driving force.
In addition, the company was very reliant upon the construction industry. Husband submitted evidence that the major factors behind the growth and increased value of the company included population growth in the Phoenix metropolitan area and the dramatic growth in the construction industry in Arizona during the marriage. Husband’s contention was further supported by the fact that as the construction industry in Arizona declined, the revenues and profits realized by the company declined as well.
Wife raised opposing arguments, including the fact that Husband worked full time, was the president of the company, and thus made decisions regarding the company’s daily operations. Wife also submitted evidence that the company’s operating agreement allowed the majority of the stockholders to exercise a control position, thus any control exercised by Husband’s father was voluntary on the part of Husband and his siblings. However, Wife’s arguments were mitigated to a certain extent by the fact that the increase in value all took place while Husband’s father was still the President and CEO, and that the revenues (and value of the company) had actually decreased after Husband became President. The bottom line is that there are numerous factors that may have led to the increased growth in a business other than the community efforts of the owner.
Similar to the other factors set forth above, the Court’s ultimate apportionment percentage may have a significant impact upon whether the community is entitled to any portion of the increased value in a sole and separate business, especially if an offsetting analysis (such as conducted inRowe and Roden) is applied as described below.
C. Offset Litigation.
As noted previously, Rowe and Roden provided an offset analysis after the apportionment stage was completed. In both cases, the courts found that the earnings received by the community offset any claim that the community had to the increase in value to the business. Under the Roweand Roden methods, a court would apply an apportionment percentage to both the increase in value, as well as to the earnings received by the community.¹ The court would then offset the “excess compensation” received by the community (the portion of the earnings that would constitute the sole and separate property pursuant to the apportionment percentage) against the community’s share of the increased value. In both Rowe and Roden, the courts assessed the community’s share of the combined sum of both the increase in value and the compensation received by the community, and then found that the community was already adequately compensated for its interest in the increased value pursuant to its receipt of excess compensation from the business during marriage.
One of the major issues argued during our case was whether overcompensation of earnings received by the community (the sole and separate portion as described above) should be offset against the community’s share of the increase in value. Although this is exactly what happened inRowe and Roden, the Rueschenberg Court threw a wrench in the analysis by providing inconsistent language. On one hand, the body of Rueschenberg states that such offset is part of a contemporaneous analysis of both the earnings received and increase in value. On the other hand, footnote 9 of the opinion gives rise to the argument that such combined or contemporaneous analysis may arguably not take place if the funds received by the community were co-mingled, or if waiver other equitable considerations preclude the offset.²
In support of our position that the offset was warranted, we cited the following language fromRueschenberg, which explains:
Rather, as we describe more fully below, we hold that the trial court must equitably apportion the combined total of the profits (net distributable earnings) and increase in value (whether goodwill or otherwise) of the separate business if the efforts of the community caused a portion of that increase and substantial justice requires it.Rueschenberg, 196 P.3d at 857 (emphasis added).
Rueschenberg goes on to say:
Cockrill, as explained above, then rejected the all or none rule in favor of an apportionment rule, stating that “profits [and/or increase], which result from a combination of separate property and community labor, must be apportioned accordingly. Id. at 858 (emphasis added).
Rueschenberg addresses the Roden case, and explains that Roden did not assess whether the community was adequately compensated pursuant to a fair salary as argued by the husband, but rather determined that “the increase in value of [the separate business], which resulted from community efforts, was offset by the amount of compensation – community property – that each party received during the marriage.” Id., 196 P.3d at 859 (citing Roden, 949 P.2d at 71).
Rueschenberg then goes on to state:
If, as a result of its receipt of the funds, the community already had received more than its proportionate share of the total profits and increase in DMM, and the trial court used the reasonable rate of return method to award the community additional monies, that may violate the fundamental rule from Cockrill to apportion the increase equitably. Id., 196 P.3d at 861 (emphasis added).
Similarly, the Rueschenberg Court explained that Rowe did not reach the conclusion that the community was not entitled to additional funds on the grounds that it had already received fair compensation. Rather, the community was not entitled to a share of the increase in value because the community received excess compensation that offset its share of the increase in value of the company. The Rueschenberg Court explains:
Here, the principle from Rowe teaches that if the two-thirds/one-third ratio allocating growth in DMM applies to both profits (net earnings) and value (here, goodwill) then it could be an abuse of discretion for either the community or the separate property to receive more than its proportionate share of the combined total. Id., 196 P.3d at 861 (emphasis added).
This analysis is further shown in the last paragraph of the Rueschenberg opinion:
To prevail on this argument, Husband would be required to show at a minimum that the community received more than it’s pro rata share of the combined total of net distributable earnings, and increase in goodwill. Equally, and conversely, he would have to show that he received less than his pro rata share of the earnings as separate property. Id., 96 P.3d at 862.
Thus, it was our position that the apportionment analysis must apply to both the earnings received and increase in value (a combined analysis that provides for a contemporaneous offset).
If one were to rely upon the language of the cases cited above, a co-mingling defense pursuant to footnote 9 of Rueschenberg makes absolutely no sense. In order for the community to have received excess compensation, there must be co-mingling. The alternate scenario is that the sole and separate owner would foresee in the future what a court would determine is the sole and separate versus community portion of his or her earnings, and thus segregate the sole and separate portion of his / her earnings to avoid co-mingling. However, if this happened, the community would not have received overcompensation and thus the combined analysis discussed in the body of the Rueschenberg and Rowe / Roden opinions would never take place.
The location of footnote 9 follows the language in the main body of the opinion that it would be an abuse of discretion for either the community or the separate property to receive more than its proportionate share of the combined total. Id., 196 P.3d at 861. The mathematical analysis set forth by the footnote 9 hypothetical is consistent with the Rowe and Roden analysis. Such consistent analysis changes, however, when one reaches the word “unless.” Starting with the word “unless,” the Court addresses “equitable considerations” such as co-mingling, waiver and estoppel. The footnote then goes so far as to state that the sole and separate property owner could even claim reimbursement if the community received more than its fair share.³ Such references are directly contradictory to the analysis and language in Rowe and Roden, and directly contrary to the analysis by Rueschenberg in the main body of the opinion. This is clearly contrary to an apportionment of the “combined” totals as explained throughout the Rueschenbergdecision, and as addressed by the Rowe and Roden opinions. Because this additional language is set forth only at the end of a hypothetical example, and because it would undercut the holdings of the opinions that require a combined analysis, it was our position that the additional language is dicta.
The Rueschenberg Court, by including its language regarding co-mingling in footnote 9 also misses the fact that the co-mingling issue was addressed in the Rowe decision. In Rowe, the trial court acknowledged that “it could not accurately trace the commingled community contributions.” Rowe, 744 P.2d at 719 – 720. The Rowe Court, however, found that it was not addressing a co-mingled bank account, and that such tracing rules do not apply to the analysis of a sole and separate business, i.e. whether the community has been adequately compensated. Id. at 720.
The co-mingling argument makes sense at first glance – if the funds are co-mingled and cannot be traced, they become community property and thus there is no sole and separate portion to offset.⁴ However, this is not what was done in Rowe and Roden, and is contrary to the language in Cockrill and in the main body of Rueschenberg.
Without taking a side one way or the other, it is clear that further clarification from the higher courts is necessary. Either co-mingling should preclude a combined analysis, or a combined analysis should take place regardless of co-mingling. The amount of money at issue may be very significant. Until further clarification is provided, we as practitioners have no choice but to take opposite positions on the issue depending upon whether we represent the owner spouse or non-owner spouse.
D. Potential Hybrid – Application of Special Master Methodology PLUS the Rowe / Roden Offset.
It is easy to read the Rueschenberg opinion as providing for mutually exclusive methods – either (1) the Special master methodology (rate of return followed by apportionment, with no offset) or (2) a Rowe / Roden approach (no rate of return, with apportionment, and that includes the offset). However, a closer review of the Rueschenberg opinion makes it clear that its conclusion is not so restricted.
Similar to what the Special Master did in Rueschenberg (a hybrid between the Fair Return Methodand a Rowe / Roden apportionment method), there are any number of additional hybrid possibilities. In our case, we argued that although the Special Master did not provide an offset inRueschenberg, nothing prevented the finder of fact from doing so in our case – even if a rate of return was first provided to the sole and separate owner. As noted above, Rueschenberg held that the husband did not present the argument that the excess income realized by the community should be offset against the increase in value, and was thus precluded from doing so on appeal. This of course suggests that such argument can and should be made, even if the sole and separate owner has already received a fair rate of return before the apportionment analysis is applied.
On the other hand, whether such offset should be provided after a rate of return is applied may also depend upon whether a fair rate of return includes only capital appreciation or both capital appreciation and income. If a fair rate of return is based upon what a hypothetical investor would require (i.e. commensurate with the discount rate), such would arguably include both anticipated capital appreciation and income. Thus, the receipt of both a high rate of return and an offset could arguable constitute double dipping, i.e. the sole and separate owner would receive a rate of return which includes expected income, as well as an offset based upon the income received by the community.
E. Litigation Regarding What Constitutes “Net Distributable Earnings.”
Another issue that came up in our case regarded what earnings are subject to an apportionment and offset analysis. The issue came up as a result of ambiguous, and at times conflicting, language in Rueschenberg and other decisions regarding the terms “net distributable earnings,” “earnings,” “compensation,” “profits,” and other references.
These various terms apply to whether the community received its fair share of the earnings produced by the business pursuant to its community efforts, and whether the community has already been adequately compensated for its share of the increase in value pursuant to its receipt of what would otherwise constitute the sole and separate owner’s portion of the earnings during the marriage. This analysis of course applies in the event that the Court does not find that the co-mingling of earnings precludes such offset.
In our case, it was uncontested that the community received substantially more earnings in the form of salary, bonuses, and shareholder distributions during the marriage than what constituted reasonable or normalized compensation. While it was Husband’s position that all earnings received by the community in excess of reasonable compensation were subject to an apportionment and offset analysis, it was Wife’s position that Rueschenberg defined the term “net distributable earnings” in a more restrictive manner, and thus only some of the excess earnings received by the community were subject to an apportionment and offset analysis. Specifically, Wife contended that pursuant to the definition of “net distributable earnings” described inRueschenberg, Husband could only receive credit for the sole and separate portion of income received by the community in the form of shareholder distributions, and should therefore receive no credit for excess compensation received in the form of salary and bonus distributions. The language relied upon by Wife in the Rueschenberg opinion was the following:
There was no request, however, by Husband to determine the amount of net distributable earnings (generally, income less salary and other expenses) generated by DMM during the marriage. Id., 196 P.3d at 854 (emphasis added).
Thus, it was Wife’s contention that net distributable earnings do not include salary or bonuses received by Husband even if such salary and bonuses were substantially higher than reasonable compensation paid to a third party.
Husband’s expert, on the other hand, testified that such segregation between salary, bonuses, and shareholders distributions would make no sense as applied to closely-held corporations because the owners have utmost discretion in how much to pay themselves in salary, and how much is distributed pursuant to bonuses and other distributions. (See “PPC’s Guide to Business Valuations” page 4-25 “Since most closely held businesses are managed by their owners, some of the companies’ profits may be included in owner’s salary expenses. . . . owners may pay themselves excessive salaries instead of dividends to reduce their total tax liability.”).
As noted previously, Rueschenberg is inconsistent with regard to the language it uses to reference the earnings that would be subject to offset or credit against the community’s share of the increase in value. In addition to the term “net distributable earnings,” Rueschenberg refers to the term “profits” or “total profits.” Id., 193 P.3d at 855-57, 860-61. Rueschenberg also addresses the term “net earnings” as synonymous with the term “net distributable earnings” and with the term “profits.” Id., 193 P.3d at 857, 860, 861. Rueschenberg then only uses the term “earnings,” i.e. [e]qually, and conversely, he would have to show that he received less than his pro rata share of the earnings as separate property.” Id., 193 P.3d at 862. In footnote 9, Rueschenberg refers to both the terms “net earnings” and “net distributable earnings.” Id. at footnote 9. In footnote 11,Rueschenberg only refers to “net earnings.” Id. at footnote 11.
Such is placed in further context by Rueschenberg’s discussion of reasonable compensation.Rueschenberg held that the receipt of reasonable compensation by itself does not necessarily mean the community has been fully compensated, and that the community should be entitled to its percentage of both profits and increased value based upon the apportionment of community labor. Id., 193 P.3d at 858-859. In discussing Roden, Rueschenberg then goes on to note thatRoden attributed its offset based upon the amount of “compensation” received by the community (as opposed to net distributable earnings):
This took place as the trial court applied, and this court affirmed, an “offset of the community’s share in the increase in value of the separate property in light of the amount of compensation previously paid the community.” Roden, 190 Ariz. at 411, 949 P.2d at 71.
Id., 196 P.3d at 859. Thus, while using the term “net distributable earnings” in some parts of its decision, Rueschenberg refers to the total amount of compensation received by the community in the body of its opinion, as well as in its citation to Roden.
A query of cases in the United States that use the term “net distributable earnings” results in only four reported cases. Two of them are Rueschenberg and Rowe. The other two are a bankruptcy and a probate case that have nothing to do with the apportionment of increase value to the business, and set forth no definitions of the term.
The Rowe decision refers on only one occasion to the term “net distributable earnings.” Rowe, 744 P.2d at 721. However, Rowe does not directly provide a description of what the term means for purposes of its analysis. In fact, Rowe included pension and profit-plan contributions in its analysis of what the community received by way of net distributable earnings. Id., 744 P.2d at 722. Rather than making a distinction between salary and other distributions, Rowe found that the overall compensation received by the community satisfied its interests in the increased value of the company. Id. Moreover, Rowe specifically states “that a community may be fairly compensated by salaries and draws received prior to dissolution.” Id., 744 P.2d at 722 (emphasis added). Thus, although the Rowe Court uses the term “net distributable earnings,” its analysis included both salaries and draws, as well as pension and profit sharing contributions, i.e., all forms of compensation to the community.
In Roden, the Court also looked to the total compensation received by the community, and did not distinguish between salary and other types of distributions:
Here, the trial court found that the increase in value of Desert Subway, Inc., which resulted from community efforts, was offset by the amount of compensation – community property – that each party received during marriage. Roden, 949 P.2d at 71 (emphasis added).
Until further clarification is provided by the higher courts, it appears that the debate over what constitutes compensation subject to an apportionment and offset analysis will continue.
F. Litigation Regarding Whether Excess Cash And Assets Are Included On The Value Side Or As Undistributed Distributable Earnings.
In Rueschenberg, the Court found that “the marital community received virtually 100% of net distributable earnings during the marriage.” Id., 196 P.3d at 861. In our case, not all of the earnings had been distributed.
In Section III, supra, regarding business valuation issues, I discussed the fact that operating assets and cash are part of the overall value of the business pursuant to an income approach, which are not added to value while excess cash and non-operating assets are not included in the base valuation, and thus need to either be added to value, or in an apportionment case, either added to value or treated as undistributed assets.
In a case where the court allows for an offset of the sole and separate portion of the income received by the community against the community’s share of increase in value, it may not matter if excess cash and non-operating assets are added to the valuation side of the equation or are treated as undistributed assets. If the community has already been adequately compensated, the sole and separate owner would arguably be entitled to retain the undistributed earnings and assets.
If the Court follows the methodology adopted by the Special Master in Rueschenberg, and does not allow for an offset analysis, this issue may become significant. For example, if the fair rate of return to the sole and separate owner is high enough, the methodology may eliminate any claim by the community – even after adding excess cash and non-operating assets to the value. However, if the excess cash and non-operating assets are not added to the value, but instead treated as undistributed assets or earnings, the community may still receive a portion of the undistributed assets so long as no offset analysis is applied.
In some ways, Rueschenberg provides clarification regarding the various methodologies and principles involved in apportionment cases. On other fronts, the opinion creates additional questions and issues.
For those looking for a “bottom line” answer how to solve an apportionment case from the language of the Rueschenberg opinion, the bottom line remains: the trial court “is not bound by any one method [of apportionment], but may select whichever will achieve substantial justice between the parties.” Id. at 858 (citing Cockrill v. Cockrill, 124 Ariz. 50, 602 P.2d 1334 (1979)).
*Special thanks to Frank Pankow, Jeff Pollitt and Barry Brody for their review and editing contributions.
William D. Bishop
Bishop Law Offices, P.C.
¹ This could be the same apportionment percentage or a different percentage. The experts in our case both concluded that no distinction should be made based upon our facts. No such distinction was made in Rowe and Roden, although footnote 9 to theRueschenberg opinion does address the possibility.
² Footnote 9 provides a hypothetical example that may add clarity. Assume that a ratio of two thirds/one-third was determined to apply to the share due the community and separate property, respectively, for its contribution to the growth of the business. Assume the amount of net earnings was $80 and increase in value was $20. The combined total of the increase is $100. The community would be entitled to $66.67, and the sole and separate property would be entitled to $33.33. If the community had already received $80 from net distributable earnings, it may not be entitled to any further amounts unless issues such as waiver, commingling, or other equitable considerations required otherwise. In fact, under this hypothetical, the sole and separate property owner may claim monies from the community if there are no other pertinent factors.
³ Additional reimbursement after such offset to the sole and separate owner is clearly contrary to case law regarding co-mingled funds. Such is entirely different than the analysis of whether the community has been adequately compensated by its receipt of earnings in the manner addressed in Rowe and Roden.
⁴ If the Court determines that an offset is not generally appropriate as a result of co-mingling, waiver or estoppel (i.e. per footnote 9 of Rueschenberg), potential issues may still arise regarding funds which were generated by the business, but not co-mingled. An example is where the owner spouse contributes to a 401K or other retirement account from the business revenues. Another example includes excess cash and other non-operating assets if such are not already included in the valuation. Since such funds or assets are not co-mingled, an argument can be made that such are subject to apportionment.