Common flaws in family business legal structures in the Middle East and the resulting risks

External threads to middle eastern families in business

Middle Eastern family business legal structures often reflect serious and potentially catastrophic weaknesses through  failure to shield and protect the founder and the core assets from serious business and legal risks.

Introduction

  1. There is a strange paradox associated with Middle Eastern businesses. On the one hand, family businesses are the real strength and spine of the Middle Eastern economies. Alongside sovereign enterprises, family businesses dominate the business landscape. On the other hand, close examination of particular Middle Eastern family businesses, even very large ones, frequently reveals frailties and fault lines which expose them to external business risks; and to far less visible threats from the inside.
  2. In many cases these weaknesses will not be obvious to the outside observer, or even to the families themselves.

External Business Threats

  1. Typically, Middle Eastern family businesses are highly diversified and have many compartments. Unfortunately, the famous 1912 shipwreck the RMS Titanic also had many compartments – but because those compartments were not totally sealed and separated the Titanic sank to the bottom of the ocean when the ship tilted and the rushing waters flooded over the dividing walls into every compartment.
  2. The typical Middle Eastern family business is completely exposed to a disaster in one compartment of the business spreading to the other compartments. Why? The answer is that there are serious weaknesses evident in the most commonly used family business structures, e.g:

(a) businesses are often set up as sole establishments owned by an individual within the family (often the founder) therefore one catastrophe (e.g. a fire in a large building owned by the founder himself) carries financial consequences and exposures directly to the core of the family’s asset base; (b) many families operate an array of businesses through registering multiple branches of a family “mother company”, a shoddy structure design. Taking this cheap and convenient shortcut means that every liability of every branch is a direct liability of the core mother company (usually the company which owns all the major assets); and (c) failure to have a coherent corporate structure often leads to the twin evils of reliance on borrowings secured by personal guarantees and a failure to track and identify adequately the performance or losses of individual businesses within the family’s portfolio.

  1. For the above reasons, many family businesses in the Middle Eastern inhabit glass villas – and any major hailstorm will prove catastrophic.

What Can Families Do?

  1. Good legal advice can help families. For example:

(a) create a corporate legal structure for the family which has watertight compartments; (b) isolate “blue chip” investment assets from entities carrying on trading enterprises with business risks and borrowings; (c) create a corporate legal structure which is both bankable and “deal friendly”;

Conclusion

  1. Many Middle Eastern families run enormously successful and growing enterprises, using “cutting edge” business models and technology. Yet, all too often their legal infrastructure is shoddy, creaky, rusty and dangerous. It is high time families overhauled their legal infrastructure, before a setback in one compartment sinks the entire ship

Note: An extended version of this article was first published in “The Oath”, the Middle East Law Journal for Corporates in May 2014.