Rounding Out the Team: When and How to Engage a Financial Planner to Apply State of the Art Financial Tools & Techniques in Complex Divorces
Author: Belinda Hanson, Tim Keating (Keating Wealth Management)
Contributing Authors: Gianna Assereto, Jane Taylor
Published: American Academy of Matrimonial Lawyers - Northern California Chapter
I. Introduction
The financial world has gotten very complicated...
This article addresses the nature and scope of the short and long-term financial issues that a family law attorney must evaluate during a divorce case, and makes the case that a sophisticated financial planner/advisor should be hired up front, during the pendente lite phase, and not at or near the end of the case—as has been the traditional approach.
Over the last two decades, marital estates in California have become both much larger, in part because of the meteoric growth in the value of tech companies—both private and public, and increasingly complex, as result of the proliferation of alternative investment vehicles of all kinds (e.g., venture capital, private equity, hedge funds and other private and illiquid investment structures).
Correspondingly, there are now increasingly complex financial and investment- related issues that arise upon a married couples’ separation. For reasons that we will explore, it is essential that these issues be evaluated early in the case, along with the typical pendente lite issues (e.g., support, custody, housing, interim payment of expenses, etc.), through and until final resolution. The best solution is for a family law attorney to employ an interdisciplinary approach, coordinating the analysis and advice from a wider circle of financial experts, including: forensic accountants, tax specialists, financial planners/advisers, valuation experts, estate planners, and other “micro” experts and specialists, as needed.
II. Preliminary Financial Analysis to be Considered by Family Law Attorneys
At a high level, there are three phases to a divorce case after the Petition/Response have been filed: (i) temporary or pendente lite orders; (ii) disclosures, discovery, and analysis of assets and income issues; and (iii) settlement or trial.
At the outset of a case, the retained family law attorney should determine the immediate needs of their client (e.g., temporary support, custody, housing, responsibility for interim expenses, attorney’s fees and costs, etc.) and how best to obtain pendente lite orders addressing the same. The purpose of such pendente lite orders is to maintain the status quo for each party and to hold the assets in such a manner that the Court satisfies the policy of the State of California, specifically:
(i) to marshal, preserve, and protect community and quasi-community assets and liabilities that exist at the date of separation so as to avoid dissipation1 of the community estate before distribution,
(ii) to ensure fair and sufficient child and spousal support awards, and
(iii) to achieve a division of community and quasi-community assets and liabilities on the dissolution or nullity of marriage or legal separation of the parties as provided under California law.2
In order to best preserve the community property, the family law attorney must immediately assess the level of financial complexity present in the case. As part of this determination, a family law attorney’s due diligence should include, when relevant, a review of the marital estate, including their investment portfolio. Among other matters, this preliminary due diligence should seek to identify any potentially complex or red flag issues involving the following:
Concentrated stock positions, restricted securities, unusual asset allocation, lack of diversification, margined accounts, accounts at foreign banks, and leveraged instruments of any kind;
Amount of overall cash, relative to living expenses and the size of assets;
Alternative investments;
Real estate, including evaluation of the interest rate on the mortgage;
Privately held businesses;
Equity compensation arrangements, including stock options, restricted stock, restricted stock units, deferred compensation, 10b5-1 plans (SEC safe harbor for insider selling), and similar structures; and
Debts and all liabilities.
If any of these issues raise concern, then it may be prudent or necessary to obtain an agreement or court order to change the investment structure and/or rebalance the portfolio pending divorce.
Once the high-level financial survey has been completed by the family law attorney, the next step is to determine which of the following experts will be needed as part of the team: forensic accountant, tax specialists, valuation experts, estate planners, and/or the focal point of this article, financial planners/advisors.
III. Attorneys and Forensic CPAs: The Traditional Family Law Team
Traditionally, the family law attorney and the forensic accountant (and/or valuation expert, if necessary) have been the two primary members of the professional team. Forensic accountants are often retained to determine a spouse’s true income, analyze the marital standard of living, prepare a post-separation accounting, and characterize and value the community and separate property. Forensic accountants are also trained to examine personal and business financial records with an eye not only for what they show, but for what is missing or potentially being intentionally withheld. This can include padding payroll, underreporting income, overpaying creditors, creating fake debt, transferring assets to dummy corporations, and the list goes on. However, forensic accountants are not forward-looking. They do not untangle the mess, organize and classify the assets, or plan for the client’s future.
A. Rounding out the Team: The Advantages of Adding a Financial Planner/Advisor at the Outset
Given the amplified complexity in family law cases with larger estates, it has become increasingly common to involve an estate planner and tax specialist early in a case to evaluate cross-over issues. Analysis of such estates often includes, (i) preparation of trans- generational wealth plans; (ii) minimization of taxes as part of asset division; and (iii) evaluation of potential breaches of spousal fiduciary duties by making investments or gifts without the other spouse’s consent. As part of the pendente lite evaluation of the case, family law attorneys routinely send a copy of the existing estate plan to an independent estate planner for review and analysis. But, again, estate planning attorneys are neither equipped to, nor in the business of, advising clients about financial planning or how to invest their money.
It is less common, but equally important, for family law attorneys to engage a financial planner/advisor to evaluate the totality of the marital estate, including all assets (whether marketable securities, businesses, real estate and other property of all kinds) and liabilities. The current investment portfolio should be immediately evaluated to determine if there are short-term issues or risks that should be addressed/remediated as part of obtaining the pendente lite orders in a case. Since divorces typically take 12-18 months and, it is therefore essential to ensure that all of a client’s “short-term” issues are managed carefully such that the financial status quo pending the divorce is optimized, to the fullest extent possible. Retaining a financial planner/advisor early can play a key role in optimizing your client’s financial future (and peace of mind).
B. Engaging the Financial Advisor
In determining whom to retain as the financial advisor, family law attorneys should consider the advisor’s role, scope of assignment, compensation and written deliverables.
1. Determining the financial advisor’s role
Consultant. Financial advisors can be retained as the family law attorney’s consultant by means of a Kovel Agreement, named after United States v. Kovel (1961) 296 F.2d 918. A Kovel Agreement allows a lawyer to hire an accountant or financial advisor who reports directly to the lawyer. Assuming the Kovel Agreement is properly executed (and this is critical), the attorney-client privilege is extended to the accountant or financial advisor. By retaining the financial advisor as a consultant, their work and analysis will thereby be privileged. During the early stages of a case, when the analysis is being completed and the benefit/detriment to the client is unknown, the attorney may not want the financial advisor’s work to be discoverable. Having the attorney retain the financial advisor as a consultant mitigates this issue. It is important to note that a Kovel Agreement only applies when the accountant or financial advisor’s communications were “made in confidence for the purpose of obtaining legal advice from the lawyer.” Id. at 922. As such, all communication should always be addressed to the lawyer and the information should be limited to issues in the case.
Expert. On occasion, financial advisors are retained as testifying experts in a family law case. For example, a financial advisor may testify about the reasonable expected rate of return in an investment portfolio (typically based on historical capital market assumptions). When retained as an expert, a financial advisor’s analysis is discoverable, and their deposition is likely to be taken.
2. Crafting the scope of the financial advisor’s work
The financial advisor assists in preparing a client’s financial plan, considering both pending- and post-divorce goals, and advising as to implementation of the same. A quality financial plan should be comprehensive, holistic, date- and dollar-specific, written, and covers the duration of a client’s anticipated life. The deliverables should cover five core disciplines: (i) financial planning; (ii) investment management; (iii) tax; (iv) estate planning; and (v) insurance. The financial advisor orchestrates and coordinates the integrated conception and execution of the plan.
In addition to preparing a financial plan, the financial advisor may weigh in on matters throughout the divorce process. For example, the advisor may assist with completing the client’s financial disclosures. He or she can also review the other party’s financial disclosures, identify deficiencies, note areas requiring further inquiry and possibly advise on alternative investment strategies. The advisor may analyze brokerage account statements, and offer insight into the complete nature, scope and value of various investments. Additionally, it may be helpful to have financial advisors available at settlement conferences to aid in conceptualizing the post-divorce impact of asset division proposals. For example, the advisor may advise as to whether certain investments can and should be replicated, and if not, may assist in crafting an alternative solution for equitable allocation of the investment. Financial planners can also assist with analyzing spousal support needs and a spouse’s ability to pay support given future projected investment earnings. Though beyond the scope of this article, a financial advisor should also closely coordinate with the client’s professional team, including tax planners, estate planners, insurance representatives, to ensure a cohesive future financial plan. A summary of the interplay of these various professionals is attached as Appendix A. In sum, the financial advisor may be a key part of the team to help keep perspective on the client’s future financial goals.
3. Methods of engaging financial advisors
If a financial advisor is retained as a consultant under a Kovel Agreement, it is imperative that they are retained by counsel and not by the party. Of course, it is important that the client meet, feel comfortable with, and trust the financial advisor. To help build a lasting relationship, the financial advisor should be properly vetted. Family law attorneys can and should help with the selection process, especially during the early stages of a case when the financial advisor is serving as the attorney’s consultant. As part of this process, attorneys should ask the financial advisor about how they are compensated, alliances to any particular funds or services, particular investment philosophies, and process for working with clients. A list of key questions to ask when vetting financial advisors are included at Appendix B.
4. Compensation of the financial advisor
During the divorce, financial advisors are typically compensated on an hourly basis for consultation work. Once the divorce is finalized, clients may continue working with the financial advisor. At that stage, they may be paid a percentage of assets under management, fixed fees, hourly rates, commissions or performance-based fees. Additional information regarding the various types of financial advisors’ compensation agreements is attached as Appendix C.
IV. The Role of the Financial Advisor During the Divorce Process in Evaluating Particular Assets and Strategies
For most clients, their divorce is the largest financial transaction of their lifetime.
They cannot afford to get it wrong. It is all too easy for clients to get into the weeds on one emotionally-driven issue, and miss the bigger picture. This is an inefficient use of time, resources and energy, and ultimately detrimental to the management of the case. Family law attorneys can try to help maintain perspective for the client, but ultimately the attorney’s job falls short of long- term financial planning. Financial advisors can play a key role by helping maintain focus on the overall financial plan, and help the client see the forest through the trees.
Many “out spouses” are surprised to discover that their liquid net worth represents only a small fraction of their overall net worth. The simple explanation is that their real property and other assets (typically of the complex variety) constitute the bulk of the community estate. For organizational simplicity, we divide these assets into two categories: (i) liquid assets (e.g., cash and marketable securities, such as stocks and bonds); and (ii) illiquid assets (e.g., real estate, businesses, private equity, venture capital, hedge funds, carried interest for those managing alternative funds, non-marketable securities, and all other assets).
Financial advisors may be instrumental in helping to identify, evaluate, and strategize optimal division of these existing assets, as well as potential investment opportunities that may arise during the divorce. A check list of issues to spot in a case is attached as Appendix D. The following discussion considers particular issues related to these assets in divorce cases, and how the financial advisor may be utilized in evaluating the same.
1. Liquid Assets
a. Cash
Cash is obviously not a complex asset—unless it is frozen, encumbered, or otherwise not available to the parties. A financial advisor should immediately review the parties’ cash (and access to that cash) to determine if there is enough to pay the interim expenses, and that the cash is earning an appropriate rate of interest. Conversely, the community estate may hold an unjustifiably large allocation in cash. Depending on the pendente lite orders, financial advisors can also help strategize regarding preliminary distributions of cash to the parties—and how such cash can and should be optimally reallocated/reinvested.
b. Marketable Securities
“Marketable securities” include stocks, bonds, mutual funds, ETFs, publicly traded REITs, money market funds, and any/all other securities that can easily and readily be converted to cash. These assets are held in bank and brokerage accounts. A financial advisor should review the brokerage statements and analyze the totality of the current investment portfolio of the marital estate. This would include a review of overall asset allocation, individual securities holdings, expected return, volatility, projected portfolio income, etc.
Further, financial advisors may advise on best practices for issuing compliant notices to brokerage companies with instructions to restrict investment modifications absent joint approval of the spouses pending divorce, consistent with the requirements of California’s Family Law Automatic Temporary Restraining Orders.3
2. Illiquid Assets
a. Real Estate
Houses are both an “emotional asset” and a financial investment. A commonplace pendente lite issue in most family law cases is whether the family residence, or other real estate, should be retained by either party. A financial advisor can help the client understand the value, liquidity and cash flow issues related to real property—whether primary residence, second home, or an asset for income production. Clients need to carefully evaluate whether keeping an expensive family residence (that may not appreciate and will incur ongoing carrying costs) is wise in the context of an overall financial plan.
Because many couples have a mortgage on their family home, and/or other real property, as of the date of separation, it is prudent to evaluate and understand all the terms and conditions of the loan to determine if a restructuring or refinancing may be advisable. For example, if interest rates have dropped since the mortgage was taken out, a simple refinancing might save both parties money. Additionally, where the “out spouse” may not have sufficient historic earnings to qualify for a refinance, the advisor may help that spouse develop a plan to establish sufficient income basis from support and other earnings to do so. The financial advisor may suggest the client both: (i) obtain an appraisal; and (ii) have the home inspected to ensure there are no material issues that would adversely impact value.
b. Alternative Investments
In the past two decades, alternative investments have become both more widespread and increasingly complex. Family law attorneys are routinely encountering new, alternative investments such as cryptocurrency, unique private equity investment structures, and real estate development enterprises. It is important to retain a financial advisor who is well-versed in alternative investment structures to properly analyze these assets and advise clients as to their options with respect to the same. Oftentimes, the role of the forensic accountant ends at identifying and analyzing the value and divisibility of the current investment. The financial advisor, however, could help clients evaluate settlement options and trial strategies related to these investments consistent with their overall, long term financial plans. For example, if the advisor believes a particular investment will not generate liquidity for many years, the advisor may suggest a buy out to a client in need of immediate liquidity. Depending on the issues in each case, the financial advisor should understand and be able to advise on the full gamut of implications, including: (i) understanding the fund structure; evaluating performance (both in absolute and relative terms, over time); (ii) modeling capital calls, expected distributions and other cash flow-related issues; explaining lockups, redemption procedures and other features specific to private/illiquid investments; (iii) providing a framework for, and/or direct evaluation of, new investment “opportunities” that may be offered; and (iv) modeling expected returns (including what-if scenarios) into the overall, comprehensive financial plan.
c. Existing Investments
During the divorce process, financial obligations frequently come due on existing community investments. For example, capital calls may be required, or follow-on investment opportunities presented. The financial advisor may help develop a financial plan pending divorce to ensure sufficient cash flow to cover these existing obligations, or suggest a negotiating strategy to obtain an exemption/relief.
d. Equity-Based Compensation
Equity-based compensation can comprise a significant part of the community estate. It can be difficult to value and model such compensation because the potential benefits are uncertain and always in the future. Nonetheless, it is important to fully understand the form, value and potential financial implications of the eventual monetization of equity- based compensation in order to effectively and completely divide the marital estate. Such compensation is typically comprised of employee stock options and restricted stock.
Employee stock options come in two basic flavors: (i) non-qualified stock options (NQSOs, also known as “non-statutory”); and (ii) incentive stock options (ISOs). The governing terms and conditions, cash flow implications, and tax treatment are completely different for each type of options. In addition to a qualified tax expert, it is suggested that an experienced financial advisor advise as to how the options fit into the client’s overall financial plan.
Similarly, “restricted stock” and “restricted stock units” (or “RSUs”), though sounding similar in nature, are entirely different animals. Among other features, they each have different rights with respect to the form of issuance, voting, dividends, forfeiture, vesting, and tax consequences. Given that the immediate financial benefit of these rights is unknown, critical inquiry is warranted into their potential value, benefits and potential liabilities. As with employee stock options, a tax expert and financial advisor could be of significant value to the client to help evaluate and contextualize these critical assets as part of his or her long-term financial plan.
e. Control Securities
Family law attorneys can retrieve a company’s public financial and organizational filings via the U.S. Securities and Exchange Commission’s (SEC) Electronic Data Gathering, Analysis, and Retrieval system (EDGAR).4 However, it is suggested that analysis of these records and the publically-traded stock in the context of the SEC Rules is beyond the scope of the family law attorney’s expertise. Financial advisors may be useful in evaluating a spouse’s publically-traded stock given the particularized rules governing such assets. For example, Rule 10b5-1, established by the Securities and Exchange Commission in 2000, allows insiders of publicly traded corporations to set up a trading plan for selling stocks they own.5 Rule 10b5-1 allows major holders to sell a predetermined number of shares over a predetermined time period based on pre-determined terms and conditions (e.g., written formula or algorithm). As part of the disclosure process in a divorce involving publically-traded stock, it is important the non-stock holding spouse receive and review the applicable 10b5-1 plan to understand any such restrictions. It is suggested that counsel consult with financial advisors in determining whether and when to disclose potential trade opportunities, given the potentially conflicting disclosure obligations in the divorce case and federal securities laws and regulations proscribing the disclosure and use of insider information.6
Financial advisors can help advise clients on how, when, and why to eliminate the restrictions on the non-stock holding spouse. For example, if timing is of the essence, the authors of this article suggest rounding out the team with corporate counsel and a financial advisor to evaluate whether to bifurcate and terminate marital status, to relieve the non- stock holding spouse from being considered an insider.
f. Solutions to Concentrated Stock Positions: Options, Collars, Hedges and Other Derivatives
An issue that arises frequently in Silicon Valley is risk associated with a concentrated stock position. This occurs when one spouse holds a significant number of shares, such as founder’s shares in a company that has recently gone public through an IPO. A collar position can be created by holding an underlying stock, buying an out of the money put option, and selling an out of the money call option. Collars may be used when investors want to hedge a long position in the underlying asset from short-term downside risk. Sometimes a concentrated stock position may be coupled with a collar, put, swap, or some other type of instrument designed as a hedging vehicle.
Only a derivatives product specialist, or a qualified financial advisor with credentialed derivative product experience, should advise on stock options (of any type), and hedging strategies of all kinds. Of course, tax implications have to be fully considered and incorporated into any analysis and associated recommendation.
g. Tax Loss Carryforwards
Another potential asset to consider is the tax loss carryforward. This provision allows a taxpayer to carry over a tax loss to future years to offset a profit, but is subject to limitations which are often understood. The tax loss carryforward can be claimed by one of the spouses, or even a business, to reduce future tax payments. It is a unique asset in that it has no market, yet potentially significant value to one or both spouses. The skilled expertise of a financial advisor may help identify the tax loss carryforward, determine its potential applicability and value to either or both parties going forward, and help determine when and how to apply the same. Tax loss carry forwards should be identified on Disclosures and listed on the balance sheet of the marital estate so as not to be overlooked in the ultimate allocation of assets in the divorce.
h. Retirement Assets
Although retirement assets are typically comprised of plain vanilla marketable securities, they are effectively illiquid because they cannot be withdrawn prematurely without incurring taxes (treated as ordinary income) and penalties. Also, there are a variety of nuanced Social Security “claiming strategies”—based on age, work and martial circumstances—and these need to be carefully examined for optimization. Financial advisors can help explain and advise on the different forms of retirement accounts (e.g., IRAs, SEP IRAs, 401(k)s), and also recommend funding amounts, asset allocation, and plan for the issues related to the new withdrawal requirement rules that went into effect with the implementation of the SECURE Act on February 1, 2020.7
3. Investment Opportunities Presented During Divorce
During the pendency of a divorce, spouses have an obligation to make investment opportunities available to the community.8 This obligation is consistent with spouses’ continuing fiduciary duties owed to one another in transactions between themselves which impose a duty of the highest “good faith” and “fair dealing.”9 In many cases, investment opportunities arising during the divorce may be in the form of items on the illiquid asset list above such as company stock, alternatives (of any and all kinds), and private placements. The investment opportunities presented may be follow-on investments to existing positions or new stand-alone investments. Financial advisors can help advise clients on whether or not to participate in such investment, considering the context of his or her overall financial plan. Again, the need to look at the “forest” at all times is critical. In all cases, the expected return, volatility, tax and potential cash flow implications have to be analyzed relative to the likelihood of the achievement of the client’s financial goals.
V. Conclusion
Financial issues presented in divorce cases are becoming increasingly complex. Gone are the days of allocating a house and a retirement account. Equity compensation packages have become so layered with complexity they often come with voluminous agreements and addendums. The proliferation of startups now requires creative modeling to fairly account for and allocate these business interests. Concentrated wealth has led to the need for highly customized financial plans, tailored to particularized needs of each family. While in the past, family law attorneys and forensic accountants were able to navigate all issues in a case, as forms of compensation expand, alternative assets proliferate, and tax issues become more complicated, it is important to have a complete team in place at the beginning of every case to ensure comprehensive client representation. In addition to the family law attorney, this may include a forensic accountant, valuation expert, tax specialist, an estate planning attorney, and a financial planner/advisor. Establishing the complete team from the beginning of the case can help shape the important pendente lite orders and significantly improve the likelihood of long-term financial success for the client.
“Dissipate" means “to cause to spread thin or scatter and gradually vanish.”
California Family Code Section 2100.
See California Family Code Section 2040.
https://www.sec.gov/edgar/searchedgar/companysearch.html, U.S. Securities and Exchange Commission, EDGAR Company Filings, last visited February 11, 2020.
This is a clarification of Rule 10b-5, created under the Securities and Exchange Act of 1934, which is the primary vehicle for investigation of securities fraud.
See In re Marriage of Reuling, 23 Cal.App.4th 1428, 1441 (“federal securities laws and regulations proscribing the use of insider information preempt any state statute purporting to impose a conflicting obligation of disclosure and use of such information.”).
Setting Every Community Up for Retirement Enhancement Act of 2019, H.R. 1994, 116th Cong. The SECURE Act, among other things, includes changes to minimum required distribution rules, liberalization of the rules governing “multiple employer plans,” and increased opportunity for part-time workers to participate in 401(k) plans.
California Family Code Section 2012(a)(2) generally provides that from the date of separation to the date of distribution of assets, each party is required to provide accurate and complete written disclosure of any investment opportunity, business opportunity or other income-producing opportunity that presents itself after the date of separation, but is the result of any investment, significant business activity outside the ordinary course of business or other income-producing opportunity of either spouse during the marriage. Such disclosure must be made in sufficient time for the other spouse to make an informed decision as to whether to not to participate in the opportunity, and for the court to weigh in to resolve any dispute.
See Family Code sections 721(b), 1100, 2100, 2102 – 2105.