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November 8, 2011

Estate Planning: Inheritance and Divorce

All’s Fair

A number of recent cases have clarified the courts’ position on dividing a couple’s assets on divorce. So how are inherited assets treated, especially where there is a pre-nuptial agreement? Marilyn Stowe and Fiona Geldart explain

Following the House of Lords decision in the case of White v White [2000] UKHL 54, there has been continuing debate among lawyers as to how inherited assets should be treated upon marriage breakdown. When determining the appropriate division of the matrimonial assets on divorce, the court has a great degree of discretion and flexibility. The factors that the court uses when deciding how the matrimonial assets should be divided are contained in section 25(2) of the Matrimonial Causes Act 1973. This article considers the application of the factors outlined in section 25(2)(a) – “the income, earning capacity, property and other financial resources which each of the parties to the marriage has or is likely to have in the foreseeable future…” – including to inherited property, and where a pre-nuptial agreement exists.

The “equal sharing” principle

Following White, the courts have re-considered their approach when exercising their discretion and flexibility under section 25. Prior to the case, the court’s approach was that, upon divorce, the party to the marriage who was financially weaker should simply have their reasonable financial needs met.

The House of Lords’ decision in White altered this approach, making the main objective instead one of fairness, as stated by Lord Nicholls of Birkenhead. However, the House of Lords was reluctant to set a precedent that the starting point for the division of matrimonial assets should be 50:50. Instead, it wished for the judge in each case to consider the section 25 factors and to make a finding accordingly. However, Lord Nicholls stated that “before reaching a firm conclusion and making an order along these lines, a judge would always be well advised to check his tentative views against the yardstick of equality of division. As a general rule, equality should only be departed from if, and to the extent that, there is a good reason for doing so.”

In the subsequent cases of Miller v Miller and McFarlane v McFarlane [2006] UKHL 24, the House of Lords went further than in White. It held that, when determining the division of the matrimonial assets, the court should apply three general principles: “needs, compensation and sharing”. It expanded upon the principle in White, stating that there should be an “equal sharing principle” in order to reflect the modernisation of marriage, whereby it is now perfectly normal for both the husband and wife to work, rather than the husband being the main breadwinner of the family. Lord Nichols expanded upon his submission in White, that “when their partnership ends, each is entitled to receive an equal share of the assets of the partnership, unless there is a good reason to the contrary”.

The decision in McFarlane has been viewed as exceptional and very much fact-specific in the way it compensated Mrs McFarlane for her own loss of career, which she sacrificed to focus on raising their family, and gave her a greater share of Mr McFarlane’s income than her reasonable needs, albeit very generously interpreted, would require. Mrs McFarlane left her career as a successful lawyer in order to spend more time caring for the family, while her husband was out at work, developing his career. This decision emphasises the provision contained in section 25(2)(f), namely to consider the contributions which either of the parties has made or is likely in the foreseeable future to make to the welfare of the family, including any contribution by looking after the home or caring for the family. Cases following Miller and McFarlane, such as RP v RP [2006] EWHC 3409 and CR v CR [2007] EWHC 3334, held that the terminology of “fairness” and “compensation” go hand in hand with the court’s application of the factors laid down in section 25(2), and that such words “should not be allowed to obscure the court’s true task”.

The equal sharing principle was echoed in Charman v Charman [2007] EWCA Civ 503, where the court held that the appropriate course of action upon the breakdown of a marriage is for the matrimonial assets to be divided equally, unless there is a good reason to the contrary. It appears that this principle has now become the starting point for the courts in determining the division of the matrimonial assets following the breakdown of a marriage.

While the factors contained in section 25(2) are not listed in any particular order of importance, it is widely acknowledged that the parties’ resources, income and capital are the determining factors.

 

Matrimonial and Non-Matrimonial Assets

There have been cases where lawyers have argued that certain assets should not be classed as matrimonial, but non-matrimonial, and therefore should not be included in the matrimonial pot.

In the case of White, Lord Nicholls gave consideration to assets which had been created outside the marriage or through the endeavours of third parties. He referred to foreign jurisdictions where there is a distinction between assets acquired by one or other party to the marriage prior to their marriage or received by gift or inheritance on the one hand and assets acquired during the course of the marriage which, by their nature, can be regarded as ‘matrimonial property’.

Lord Nicholls, and it cannot be summarised any more succinctly than this, goes on to say:

Property acquired before marriage and inherited property acquired during marriage come from a source wholly external to the marriage. In fairness, where this property still exists, the spouse to whom it was given should be allowed to keep it. Conversely, the other spouse has a weaker claim to such property than he or she may have regarding matrimonial property.

Plainly, when present, this factor is one of the circumstances of the case. It represents a contribution made to the welfare of the family by one of the parties to the marriage. The judge should take it into account. He should decide how important it is in the particular case. The nature and value of the property, and the time when and circumstances in which the property was acquired, are among the relevant matters to be considered. However, in the ordinary course, this factor can be expected to carry little weight, if any, in a case where the claimant’s financial needs cannot be met without recourse to this property. 

Section 25(2) is therefore not limited to assets acquired during the marriage; indeed, the courts possess the power to deal with the resources of both parties, regardless of whether they were acquired before or during the marriage. How the courts choose to deal with assets which have been inherited before or during the marriage very much depends upon the facts of the case in question and ultimately if the circumstances of the case and the financial resources of the parties are limited, then those assets may be called upon to meet the financial needs of the parties and not be left ring-fenced for the party who was the beneficiary of the inheritance.

In Charman, the court held that the equal sharing principle should apply to matrimonial and non-matrimonial assets, but that there may be a “better reason” for moving away from it in relation to non-matrimonial property. In deciding whether equality should be departed from, the court will take into consideration how the assets were acquired, and may hold that they should be retained by the party who inherited them. The outcome will however, very much depend upon the bearing of the other section 25(2) factors. Generally, one party to the marriage will not be allowed to retain such acquired or inherited property, if the other party’s needs could not be met without that property being placed in the matrimonial pot and divided accordingly, or if the marriage was of long duration. For example, in the case of S v S [2007] EWHC 1975, the judge was criticised for ring-fencing the wife’s inheritance money, when this money could have been utilised to meet the parties’ needs.

 

Treatment of Inherited Assets

So, the question arises of how inherited assets should be dealt with upon divorce, and in particular, how they should be dealt with in the context of a pre-nuptial agreement.

There have been a number of recent cases whereby the court has had to determine how best to deal with inherited assets upon the breakdown of a marriage. Following Miller and McFarlane, lawyers have continually attempted to put forward arguments which justify the departure from the equal sharing principle. However the reality is, that in many marriages of long duration, any such arguments are likely to be surpassed by the parties’ needs. Having said that, the courts are also recognising that, in cases involving parties who have only been married for a short duration, inherited assets are a significant factor.

In R v R [2009] EWHC 1267 (Fam), Mr Justice Charles held that the equal sharing principle does not apply to inherited assets or those acquired prior to the marriage; instead, how they should be dealt with very much depends upon how they have been “treated, enhanced and regarded”. Essentially, in that case, the court found that assets which have been inherited by a party prior to the marriage were to be dealt with differently to those acquired during the marriage.

In L v K [2010], Mr Justice Moylan held that “almost all the wealth in this case has been inherited by the wife … as a result, there is no matrimonial property as referred to in Miller and McFarlane“. The wife therefore retained her assets, and the husband retained his £100,000. The husband appealed this decision (K v L [2010] EWCA 125), but his appeal was dismissed.

In the case of K v L [2010] EWHC 1234 (Fam), Mr Justice Bodey said that he had not been “persuaded that the pursuit of fairness requires the court, in attempted recognition of the abstract concept of sharing, to take further money from the wife’s pre-marriage inheritance so as to further enhance the husband’s post-divorce financial circumstances”. The husband was awarded £5m. The court took the view that the offer of £5m made by the wife to the husband was entirely reasonable and surpassed the husband’s reasonable requirements. The court did not think that it was fair in such a case involving so much money, to dive into the wife’s pre-marital inheritance, just so that the husband could obtain a more advantageous settlement. Clearly, if the needs of the parties cannot be met by omitting to include pre-marital inheritance in the matrimonial pot, then it is wholly prudent to include it, and to divide it accordingly. The Court of Appeal recently upheld Mr Justice Bodey’s decision (K v L [2011] EWCA Civ 550), emphasising that it was not necessary to award the husband a share in the pre-marital inheritance when his needs had been met.

In N v N [2010] EWHC 717 (Fam), the stance of the court seemed to be that the equal sharing principle is not just about percentages, but about outcomes. The court believed that it would not be fair for the husband to dispose of assets which he had inherited, just to achieve a clean break.

In of N v F [2011] EWHC 586 (Fam), Mr Justice Mostyn considered the current approach of the courts with regard to inherited assets, and provided his view as to how such assets should be dealt with. The parties were married for 16 years, with assets totalling £9.7m. The husband owned assets worth approximately £2.1m when the parties married. Mr Justice Mostyn held that Lord Nicholls had laid down perfectly in the case of White why inherited assets or assets acquired prior to the marriage should be considered and treated differently to matrimonial property. The longer the marriage lasts, however, the more realistic it may be to say that the party to the marriage who inherited has effectively agreed to share the fruits of this inheritance with his spouse.

In the same case, Mr Justice Mostyn stated that there have essentially been two approaches taken by the courts with regard to how inherited assets and assets acquired prior to marriage should be dealt with upon divorce. The first is that the equal sharing principle should be departed from; Mr Justice Moylan took this approach in C v C [2007] EWHC 2033, in which the wife was awarded 40% of the total assets so as to reflect the more substantial contribution made by the husband prior to the marriage. The second, and the one Mr Justice Mostyn said he preferred, is to consider the length of the marriage and whether, and if so, how, inherited or pre-marital assets were mixed with the matrimonial property, and use that as the basis of the decision as to whether, and if so, to what extent, those inherited or pre-marital assets should be considered.

Finally in the case of Jones v Jones [2011] 1 FCR 242 and [2011] EWCA Civ 41, which overturned the decision of Mr Justice Charles in J v J [2009] EWHC 2654 (Fam), Lord Justice Wilson took the same view as Mr Justice Mostyn in N v F. The husband owned assets of approximately £2m when the parties married, but the fair value of the business (given the “latent potential” of the company at that date) was held to be around £9m. After the couple had separated but before they divorced, the business was sold for somewhere in the region of £25m. The court held that £16m should be considered as matrimonial property, and awarded the wife £8m, as it saw no reason why the equal sharing principle should be departed from.

It is important to stress here that these decisions, while providing general guidance on the treatment of inherited assets, still need to be read in the context of the factual matrix of each case to understand how and why a particular decision has been reached. It is also worth remembering that most cases that find their way to the High Court or the Court of Appeal and thus considered to be of such legal importance or interest to be reported involve litigants who have the financial resources to pay for the very best legal representation and to risk the costs of further appeals; and who, therefore, may already have an excess of capital and income over and above what they actually need to live on. They are often arguing about how to divide up “the icing on the cake”.

 

Pre-nuptial agreements

There are an increasing number of cohabiting couples entering into cohabitation agreements, which govern what will happen to their property and chattels upon the breakdown of the relationship. Cohabitation agreements are generally considered to be binding, subject to the principles under contract law.

But what happens if a couple about to be married wish to enter into a pre-nuptial agreement, and how do the courts view inherited assets in this regard?

Historically the attitude of the court towards towards pre-nuptial agreements had been dismissive. In N v N (Jurisdiction: Prenuptial Agreement) [1999], [1999] EWHC Fam 838 and MacLeod v MacLeod [2008] UKPC 64, the court held that such agreements were not binding under English law, on the grounds of public policy. However, Lord Justice Thorpe, in the recent case of Radmacher v Granatino [2009] EWCA Civ 649, stated that, in his opinion, the public policy rule was “increasingly unrealistic, as it reflects the laws and morals of earlier generations. It does not sufficiently recognise the rights of autonomous adults to govern their future financial relationship by agreement.”

Radmacher v Granatino proceeded to the Supreme Court, the judgment of which was eagerly awaited. The Supreme Court, by an 8:1 majority, restructured the court’s approach with regard to pre-nuptial agreements. It made a number of important observations, the key one being: “The court should give effect to a nuptial agreement that is freely entered into by each party with a full appreciation of its implications, unless in the circumstances prevailing it would not be fair to hold the parties to their agreement.”

When advising clients as to the merits of pre-nuptial agreements, it is essential to emphasise the following points.

First, while pre-nuptial agreements are not legally binding, they can certainly be persuasive to the court, and there is now a presumption in their favour, following the extinction of the argument that they should be void on the ground of public policy.

Second, the court will need to assess all the circumstances of the case at the time that the agreement was made between the parties. Among other things, this means that the court will want to ensure that the parties have been as transparent as possible as to their disclosure of assets, and that one party has not suffered undue influence at the hands of the other to sign the agreement.

Third, the court will have to consider the circumstances of the case upon the breakdown of the marriage. If the terms of the agreement do not adequately provide for the family’s needs, especially where there are children of the family, it is likely that provisions which are alternative to the agreement will have to be made in order to meet these needs. For example, if the parties have excluded any inherited assets from their agreement, the courts may step in and ensure that such assets are taken into consideration when deciding on a fair outcome if they are required to meet the needs of the parties.

It is perfectly understandable that people want to enter into pre-nuptial contracts to protect their assets, particularly in circumstances where they are to enter into a marriage already in possession of pre-acquired assets through inheritance or with the likelihood that they will acquire a substantial inheritance in due course, is perfectly understandable. Inevitably pre-nuptial agreements are intended for parties who are actually bringing something of financial value into the marriage. If people enter into a marriage with no or limited assets, what is there really to protect? With the best of intentions at heart, the statistics showing the high number of divorces each year will cause even the most romantic to think with a commercial head about how they can best protect themselves in the event that their marriage breaks down. Even more likely is that parents of intended spouses will want to ensure that their hard-earned assets will also be preserved for their offspring and not become part of assets to be divided on divorce. We increasingly see attempts to protect assets through pre-nuptial agreements or the creation of trusts.

The enforceability of pre-nuptial agreements is not yet written down in statute. It is just one of the factors namely the conduct of the parties per s.25(2)(g) to be taken into consideration by the court. Its relevance and weight has increased since Granatino but to counter that we still ultimately have to look to that ever present and overriding issue of needs to consider the fairness of any intended contracted provision. While it may, therefore, be viewed that a pre-nuptial agreement is very much an agreement made and its terms controlled by the parties themselves, the court still has a strong role to play in ensuring that the assets in question are dealt with fairly upon divorce.

And finally, future legislation may come into force, changing the position as to pre-nuptial agreements further. Whether this will include specific guidance on how to deal with non-matrimonial assets such as inherited property is a distinct possibility.

This may be one of the many steps along the road towards a more European formulaic approach which provides for greater certainty of outcome but in so doing abolishes the overriding concept of “fairness”. It is understood that the Law Commission is due to release a report in 2012, so we will need to watch this space.

 

Marilyn Stowe is senior partner and Fiona Geldart a solicitor at Stowe Family Law.

 

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