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Active Appreciation of Marital Property in Divorce
© 2005 National Legal Research Group, Inc.
Active Appreciation in General
Equitable distribution theory provides that all value created during the marriage by the active efforts of one or both spouses constitutes marital property. This rule is easily applied when the active efforts are used to acquire an entirely new asset.
In some situations, however, active efforts are used to improve the value of separate property. If an asset which was so improved is treated as entirely separate property, then there would be a significant exception to the general rule that the fruits of marital efforts are marital property. Moreover, because spouses have control over which asset benefits from their active efforts, the exception would be quite large in actual practice. Many spouses with significant separate property would be able to convert their separate property into a form which would grow if improved with marital contributions. The result would be to exclude from the marital estate a significant amount of value which was actually produced by marital contributions.
To avoid this large loophole in the definition of marital property, most dual-classification states hold that the increase in value of separate property is marital property to the extent that the increase resulted from marital contributions. As a result, when dividing appreciated separate property, the court must divide the appreciation into two classes. Appreciation caused by marital contributions, known generally as active appreciation, is marital property. Appreciation caused by inflation, market forces, or the efforts of third parties, known generally as passive appreciation, remains separate property. See generally Brett R. Turner, Equitable Distribution of Property 5.22 (2d ed. 1994 & Supp. 2004).
All-property states do not distinguish between active and passive appreciation as a matter of classification, but there is case law suggesting that the court may consider as a division factor the extent to which appreciation in traditionally separate property resulted from marital contributions. E.g., In re Marriage of Steinbeisser, 313 Mont. 74, 60 P.3d 441 (2002). Thus, even in all-property jurisdictions, the fundamental distinction between active and passive appreciation is recognized.
Active Appreciation and the Separate Property Business
Of all of the types of assets to which the active/passive distinction is applied, one of the most common is the separate property business. Many spouses acquire businesses before the marriage; other spouses acquire interests in a business by gift or inheritance during the marriage. Whenever a separate property business is at issue, the court must assess the extent to which any growth in the business resulted from marital efforts.
The role of marital efforts is most easily analyzed when the owning spouse was either the dominating force behind the operation of the business or a completely passive investor. In the former situation, the strong trend is to treat all of the appreciation as active, unless specific amounts can be traced to extraordinary market forces. For cases finding the appreciation to be entirely active, see, e.g., Innerbichler v. Innerbichler, 132 Md. App. 207, 752 A.2d 291 (2000) (appreciation caused by dynamic husband who served as CEO and clearly controlled company was entirely active, even though he owned only 51% of the company, and 49% owner also worked there), and McLeod v. McLeod, 74 N.C. App. 144, 327 S.E.2d 910 (1985) (appreciation held active, largely in reliance upon broad powers of shareholder and officer of close corporation). For cases finding extraordinary market forces on the facts, see, e.g., Hoffmann v. Hoffmann, 676 S.W.2d 817 (Mo. 1984) (appreciation held passive, where record showed that it was caused by specific nonmarital source (fortuitous enactment of federal pollution control provisions which increased demand for company's products)), and Rowe v. Rowe, 24 Va. App. 123, 480 S.E.2d 760 (1997) (error to treat appreciation in newspaper stock as entirely active, even though husband was the newspaper's editor; explosive population growth in newspaper's area of circulation played a very substantial role in driving newspaper's growth, and husband's brother made major contributions as newspaper's business manager).
In the latter situation, the appreciation is clearly passive, for mere ownership of stock (or even nominal service as an officer or director) does not by itself show actual contribution. E.g., Robert v. Zygmunt, 652 N.W.2d 537, 544 (Minn. Ct. App. 2002) (wife who functioned as a nominal officer and board member, but had no real control over corporate management, created no active appreciation).
The most difficult cases are those in which the owning spouse made important contributions to the business, but did not serve as the chief executive officer (CEO) or other controlling manager. In these second-tier manager cases, the court must assess not only the effect of market forces, but also the influence of the owning spouse compared to the influence of other managers. Our main article this month will discuss several of the leading cases involving second-tier managers, focusing upon a well-reasoned recent decision arising from the State of Ohio.
Second-Tier Manager Cases
One of the first major decisions to consider active appreciation in the context of a second-tier manager was Decker v. Decker, 17 Va. App. 12, 435 S.E.2d 407 (1993). The husband in Decker was a high-level executive with a large, publicly held textile company. He did not actually run the company until late in the marriage; for most of the time the parties were married, he was the company's top vice-president. His contributions to the company were nevertheless impressive:
Apart from the non-monetary contributions of Mrs. Decker, as found by the commissioner, the record clearly demonstrates Mr. Decker's substantial contribution to the growth of PKC and the increase in value of its stock. While he was one of five key executives, his testimony described his position as "first among equals." The corporation apparently recognized his value by purchasing ten million dollars of insurance on his life, the same amount purchased on the life of the company president. No other corporate executive was insured for more than three million dollars. When allocating bonuses . . ., the corporation gave Mr. Decker a share equal to that received by the president. His value was further recognized by his dramatic rise on the corporate ladder. Ultimately, when the company needed a new president, Mr. Decker was selected for the job. He ran the day-to-day operations of the plant, was responsible for the finance division, and exercised a substantial amount of influence over the sales division.
435 S.E.2d at 411-12.
The husband owned substantial separate property stock in the company, and the issue was the extent to which the appreciation in this stock was caused by the husband's efforts. The case was initially heard by a commissioner, who held that despite the husband's status as leading vice-president, the total appreciation in the company during the marriage would be allocated equally among the five top corporate executives. The court thus viewed 20% of the appreciation as a product of the marital partnership. This finding was approved on appeal as a reasonable exercise of the commissioner's discretion.
A similar result was reached in Ellis v. Ellis, 235 A.D.2d 1002, 653 N.Y.S.2d 180 (1997). There, the husband operated a small furniture company along with five of his siblings. The husband was in sales from 1979 to 1990, and then in management from 1990 to 1993. Since the husband had been in sales for most of the marriage, the court held that it was fair to use sales figures to determine the role of the husband's efforts in the success of the company. Because the husband was responsible for 20% of the company's total sales from 1983 to the date of trial, the court affirmed a lower court decision holding that 20% of the appreciation was active.
For additional decisions recognizing a marital interest in the appreciation in a separate property business, arising from contributions as a second-tier manager, see Congdon v. Congdon, 40 Va. App. 255, 578 S.E.2d 833, 839 (2003) (where husband's "father, brother, and other key officers played more active managerial roles in the family business" than did husband, affirming trial court finding that only 10% of the appreciation in husband's stock was active), and Smith v. Smith, 197 W. Va. 505, 475 S.E.2d 881 (1996) (where husband worked for company as vice-president, error to treat all of the appreciation as passive; some portion of the appreciation was clearly caused by husband's efforts).
Herron v. Herron
The most recent case to discuss active appreciation in the context of a second-tier manager is Herron v. Herron, 2004 WL 2426307 (Ohio Ct. App. Nov. 1, 2004). It is important to note at the outset that, unlike most states, Ohio draws no distinction between the precedential value of cases which do and do not appear in the official reporters. "Notwithstanding the prior versions of these rules, designations of, and distinctions between, 'controlling' and 'persuasive' opinions of the courts of appeals based merely upon whether they have been published in the Ohio Official Reports are abolished." Ohio Supreme Court Rule for the Reporting of Opinions 4(A). Thus, while Herron has no book citation as of the time of this writing, it has full precedential value within the State of Ohio, and it should have full persuasive value in other states.
The major issue in Herron was classification of the wife's stock in a separate property business known as Robinson Fin Machines, Inc. The wife's mother was president of the corporation. During the marriage, she hired the wife and her two brothers as the corporation's vice-presidents, and gave them stock in the company. During the marriage, the company grew in value significantly.
The court described the wife's position and duties as follows:
[The wife, Sheryl,] was one of four key executives running the company during its time of unprecedented expansion. As the president of Robinson Fin, her mother served as the figure head of the company and primarily dealt with community relations. Her brother Mark, the vice president of engineering and manufacturing, was in charge of the technical aspect of developing new products, while her brother David, the vice president of sales and marketing, was in charge of selling and promoting the products. Sheryl served as the vice president of administration and was responsible for the human resources and administrative aspects of Robinson Fin.
Testimony established that prior to Sheryl's arrival, her role had been filled by Mark and David on an ad hoc basis. Thus, Sheryl's employment allowed them to focus exclusively on their respective fields without extraneous distractions. There was also testimony that the complexity of Sheryl's job had increased as the size of the company grew.
Id. at *4.
The trial court held that "Sheryl was part of the reason why Robinson Fin had experienced such tremendous growth." Id. It also found, however, "that the four executives were part of a team effort, each contributing to the success of the company with his/her own unique expertise." Id. The court therefore found that 25% of the growth in the wife's stock was active appreciation.
Both parties appealed, the wife arguing that 25% was too high and the husband arguing that 25% was too low. Quoting from the leading Ohio Supreme Court case on active appreciation, Middendorf v. Middendorf, 82 Ohio St. 3d 397, 696 N.E.2d 575 (1998), the court summarily rejected the wife's argument that she was not responsible for any of the increase in value:
Passive forces such as market conditions may influence the profitability of a business. However, it is the employees and their labor input that make a company productive. In today's business environment, executives and managers figure heavily in the success or failure of a company, and in the attendant risks (e.g., termination, demotion) and rewards (e.g., bonuses, stock options) that go with the respective position. These individuals are the persons responsible for making pivotal decisions that result in the success or failure of the company. There is no reason that these factors should not likewise be relevant in determining a spouse's input into the success of a business.
Middendorf, 82 Ohio St.3d at 402, 696 N.E.2d 575.
After reviewing the entire record, we find that there is competent and credible evidence supporting the trial court's determination that 25% of the increase in Robinson Fin during the time of the marriage was due to labor on the part of Sheryl.
Herron, 2004 WL 2426307, at *5.
The court then considered the husband's argument that the wife had caused more than 25% of the business's growth in value. The court found significant evidence that the wife's contributions, while important, were limited:
[T]here was evidence before the trial court that the growth of Robinson Fin was due to a team effort on the part of all four executives. Indeed, the official job description of Robinson Fin's president, which outlines the president's duties and responsibilities, states that the president will be accountable for the organization and performance of all the other departments. The president is also responsible for promoting the public image of Robinson Fin, customer relations, and employee goodwill. Furthermore, it was Ruth [the wife's mother] who had the foresight to bring her three children into the company. She initiated the growth of the company by hiring her children and has been Robinson Fin's president throughout its expansion. Accordingly, we find that there is competent and credible evidence to support the trial court's determination that Sheryl was only responsible for 25% of the company's growth.
Id. Thus, the trial court's determination that 25% of the appreciation was active was affirmed as against both parties' appeals.
Of particular interest in the above passage is the court's recognition that the wife's mother had created value by the simple act of bringing her three children into the company. Unlike many CEOs, the wife's mother was not the dominant force in the company; indeed, the above passage suggests that bringing the three children into the company was the key fact which led to the growth in value. Because of this fact, the husband argued that 33% of the appreciation was active, because the wife was one of the three children.
One of the most important ways in which CEOs contribute to the success of their companies, however, is through selection of personnel. Only in the smallest companies do top executives actually manufacture the goods or provide the service which makes the company profitable. The job of an executive, almost by definition, is to select and manage lower-level employees. The above passage suggests that the most important contribution made by the mother was her decision to bring the three children into the company. On the facts, the court found that that decision made the mother responsible for 25% of the growth, even though the direct cause of the growth was apparently the day-to-day efforts of the children.
While Herron did not cite Decker, there is remarkable similarity in the end results of both cases: The appreciation was divided equally among a group of top executives who were deemed equally responsible for corporate management.
It is essential to understand, however, two key limitations upon this result. First, equal allocation is clearly not a requirement of law or even a preferred practice. In both Decker and Herron, the court carefully reviewed the various contributions of all of the executives before deciding that they shared equal responsibility for the outcome. In other situations, the courts have refused to allocate appreciation equally among persons who made unequal contributions. A good example is Innerbichler v. Innerbichler, 132 Md. App. 207, 752 A.2d 291 (2000), where the facts suggested that a 51% shareholder CEO was the dynamic force behind the success of the company, even though the other 49% shareholder was also a corporate officer. Equal allocation is an option where the contributions of the leading executives were equal, but the court must give full consideration to the possibility that the contributions might not be equal.
Second, it is important to note that the businesses at issue in Decker and Herron did not have a single dynamic and domineering CEO. Again, Innerbichler is a useful contrast, for there the evidence suggested that the husband was the typical dynamic, driven corporate leader. Indeed, the 49% shareholder recognized in his testimony before the court that the husband made the major corporate decisions. By contrast, the record in Decker contained considerable evidence of contributions made by the company's vice-presidents, and did not reveal any indication of a single dynamic CEO who kept close control over major policy decisions. Likewise, the wife's mother in Herron appeared to allow her children to exercise significant control over the company, to the point where the court held that the mother's major contribution to the company was the decision to bring the children into it.
On the facts, the businesses in both Decker and Herron were operated in a manner which allowed persons beneath the CEO level to exercise significant control over operations. When the facts suggest that a business had a more active CEO when the business is more like the business at issue in Innerbichler equal allocation has been rejected.
Finally, if equal allocation becomes more common in businesses without a traditional dynamic CEO, an important battleground is likely to be the identity of the group of top managers. In both Decker and Herron, policy decisions were apparently made by a clearly identifiable group of top managers. In future cases, the facts may not arrange themselves so neatly; decisions may have been made by a less identifiable group of persons, which changed more rapidly over the course of the marriage.
In cases where the major corporate decisionmakers are not so easily identified, the equal allocation concept will be much more difficult to apply. Owning spouses can foreseeably be expected to argue for the largest possible group of second-tier managers, arguing in effect that the group should include anyone who ever participated to any extent in making a corporate decision. Equally foreseeably, nonowning spouses can be expected to argue for the smallest possible group, limiting membership to those who regularly made the most important corporate decisions.
In these cases, the better policy is to look past competing arguments over the size of the group, and focus on the overall extent to which the owning spouse was responsible for the key management decisions which led to the growth of the company. Persons who participated in the group only occasionally may have made major contributions to key management decisions; persons who participated in the group regularly may have been largely passive. Consideration must also be given, as it clearly was in Herron, to the possibility that one manager (often the CEO) may have contributed indirectly by bringing lower-level employees into the company. In cases without an easily identifiable group of top corporate executives, this contribution-based approach is likely to yield better results than the equal allocation method applied on the facts of Decker and Herron.
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