Mental capacity issues at family enterprises: prepare for the unexpected

Family enterprises are unique entities, often involving multiple generations and can be particularly complex and difficult to navigate. When mental capacity issues arise in a family business, the complexities multiply. 

Loss of mental capacity is now more than ever a growing concern.  Someone in the world develops dementia every three seconds, and of course there are many other ways to lose capacity, including age-related cognitive decline, accidents, illness and substance abuse.

We have advised on a case where an individual had several companies, some of which he was a sole shareholder and sole director.  Unfortunately, the individual lost capacity. He did not have powers of attorney in place and the articles of the company had not been reviewed.  It was not clear what was to happen, and we were instructed to advise.

There was a delay in being able to take over the running of the companies, which caused issues in the supply chain and the ability of the companies to interact.  

The individual had planned to make some gifts of his shares, to mitigate his inheritance tax position, but this was no longer possible after loss of capacity, because the Court of Protection’s authority would be required for such gifts.  This caused stress and worry for the family at an already difficult time and, potentially, a larger inheritance tax bill.

Family businesses should make sure they understand the capacity issues that could affect them and what can be done to make sure the business is prepared for all eventualities. These issues are not talked about enough. They can have profound implications for the leadership, continuity, and the future of the business.  

Being unprepared can lead to delays in making critical decisions, a breakdown in communication and governance, internal conflicts, jealousy, rivalry and a lot of stress.  Having a plan of action – or at least an understanding of what can and should be done is crucial. 

There are several key questions for family businesses to consider:

• Who makes key decisions for the business if a director is incapacitated?
• Can an incapacitated director be replaced or removed?
• What happens to a shareholder’s vote if they lose capacity?
• What happens to the shares if an owner loses capacity?
• How would capacity issues affect family relationships and business operations?
• Would incapacity impact succession plans and leadership transitions?

If a business does not know the answers to these questions, they should seek legal advice.

What can be done to prepare?

Succession planning: A clear succession plan should be made to cover issues of incapacity.  Succession planning for a family business can be documented in a Will, Articles of Association, Shareholder’s Agreement and a Family Constitution. 

Governing documents: Articles of Association and any Shareholders’ Agreement should be reviewed to understand what happens legally if a director loses capacity and the documents should be updated to ensure the outcome would be practical.  Often, old Articles do not provide for an incapacitated director to be easily removed.  

Family constitution: this is a more informal document that does not need to be written in legal terminology but instead by the family themselves, normally guided by an advisor.  Such a document can set out family values, ambitions and at which point new family members would become involved. It can ensure everyone is on the same page and has a clear understanding of the trajectory of the business and what is expected of each individual.  

Wills: Once an individual loses capacity, they cannot put in place a will.  Therefore, it is important to make sure wills are up to date and specify where business interests should pass on the testator’s death.  Articles of Association and Shareholder Agreements would need to be reviewed to ensure there are no restrictions on how the shares can be left. 

Trusts: trusts can be used to effectively manage and provide protection for business interests.  If a trust holds shares, there is no worry like there is with an individual shareholder who loses capacity and is not able to exercise their voting powers (however, the trust would need to be carefully drafted to ensure there is provision for what happens to a trustee who loses capacity).

Powers of Attorney: These enables a person who has mental capacity to choose another individual or individuals they trust (the attorneys) to make financial decisions on their behalf if they lose capacity either temporarily or permanently.  

It is possible to create property and financial powers,  appointing one set of attorneys to manage personal assets and another set to manage business assets, as it might not be appropriate for the same people to make both personal and business decisions.  

It is often wrongly assumed that family members or even business colleagues will gain automatic authority to make such decisions.  Once an individual has lost capacity, it’s not possible to put in place a power of attorney. Instead a court application for a deputyship order would be required, which is more costly, timely and likely to give limited powers compared with an LPA.

Open communication: If a family member’s mental capacity deteriorates, it is important to ensure their wishes are respected, and there is transparency in the business’s decision-making process. It is important to openly discuss concerns about aging, health, and business succession early to ensure there is a clear understanding of who will take over critical responsibilities.

Capacity issues can significantly impact a family business. Proactive planning, open communication and professional guidance are essential to navigating these challenges and to ensuring the business remains a lasting legacy for future generations.

Nicola Nottidge is a private client advisory solicitor at Birketts in London