Valuation, Distribution, and Division of Employer Issued Stock Options in Divorce: Koley Jessen

Valuation, Distribution, and Division of Employer Issued Stock Options in Divorce

06.14.2016

Few assets in a marital estate can present as many challenges to the divorce practitioner as stock options. Typically, stock options function as a salary substitute or an alternative means for compensating an employee for past or future work efforts.[1] Unlike an at-will employee’s compensation, however, stock options are contractual in nature, owned as property by the employee to whom they are granted. They give the employee the right to purchase an employer’s stock during a specified period of time, at a predetermined price.[2] Should the employer company’s stock price increase above and beyond the predetermined purchase price, the stock options can have considerable value. On the other hand, should the stock price decline below the purchase price, the stock option will not have value.

In a divorce action, the purpose of property division is to distribute the marital assets equitably between the parties. [3] Equitable division of property involves a three step process, the first of which is to classify parties’ property as marital or nonmarital.[4] As a general rule, all property accumulated and acquired by either spouse during the marriage is part of the marital estate, unless it falls within an exception to the general rule. The typical exceptions are for property acquired by one or the other spouse during the marriage by gift or inheritance, but there is no exception for property acquired by one or the other spouse through employment.[5] In fact, the legislature has provided, “The court shall include as part of the marital estate, for purposes of the division of property at the time of dissolution, any pension plans, retirement plans, annuities, and other deferred compensation benefits owned by either party, whether vested or not vested.” [6]

The nature of the stock options must be understood in order to properly factor them into the marital estate, and the concept of vesting and maturity are important. Vesting relates to when the employee can exercise the option, and maturity relates to whether the right to exercise is absolute. That said, stock options are ordinarily either (a) vested and matured, (b) vested and unmatured, or (c) unvested.[7] If the employee has an absolute right to exercise the option immediately, the option is vested and matured.[8] If the employee cannot exercise the option until some future date, but the employee has an absolute right to exercise the option on that date, the option is vested and unmatured.[9] If the option cannot be exercised until some future date and the option is subject to divestment, the option is unvested.[10]

While the grant date and the vesting date are important to know and understand, another dynamic of equitably dividing stock options in a divorce is the nature and timing of the work or services that prompted the grant of stock options in the first place. For example, stock options might be granted as a bonus for a job well done or a project completed. In that instance, the work done before the grant date is relevant to determining if the stock option is a marital or a non-marital asset. On the other hand, the stock option might be granted as part of an incentive compensation package that looks to future performance. In that instance, the work done after the grant date is relevant to determining if the stock option is marital or non-marital. Ultimately, the question for the question is whether or not the parties’ joint efforts during the marriage resulted in the grant of the stock option. If yes, in whole or in part, the stock options will be considered, in whole or in part, marital property.

The Time Rule

As we attempt to classify stock options as marital or nonmarital, the Davidson case teaches that the “time rule” generally applies. The time rule has two inquiries. First it asks what percentage of the stock options was granted for past, present, or future services. Second, it asks what percentage of each portion was accumulated and acquired during the marriage.

First Inquiry - Past Present or Future Services

Obviously the language of the stock option grant and the stock option agreement will be helpful in making this determination, but the language is not determinative.[11] Relevant non-exhaustive considerations include whether the employee stock options were (a) intended to secure optimal tax treatment; (b) induce the employee to accept employment; (c) induce the employee to remain with the employer; (d) induce the employee to leave his or her employment; (e) reward the employee for completing a specific project or attaining a particular goal; or (f) be granted on a regular or irregular basis.[12]

Accordingly, if the stock options were granted as a reward for a job well done, the option would be deemed granted for past services. If the stock options were granted to incenfity the employee for work to be done in the future, the options would be granted for future services. Sometimes, the options can be granted for both purposes, or present purposes, and a percentage of past, present, and future would need to be determined for each grant.

Second Inquiry - When Was Each Grant Accumulated and Acquired?

Once the percentage of past, present, and future is determined, the court needs to determine what percentage of each grant was accumulated and acquired during the marriage. This is done by creating a fraction. Different fractions apply depending on when the grant occurred, and what the grant was for.

Grants for Past Services

If the grant was before the marriage and it was for past service, the stock option is likely 100% non-marital. This makes sense because the work to which the option relates occurred prior to the marriage and the joint efforts of the parties did not contribute to the grant of the option.

If the grant occurred during the marriage and was for past service, the stock option may be marital or non-marital. If the period of service to which the option relates was during the marriage, then the stock option will be 100% marital. But if the period of past service to which the option relates occurred in part before the marriage, and in part during the marriage, a coverture fraction needs to be created in order to determine the marital and non-marital portions. In this instance, the numerator would be the period of time from the date of the marriage to the date of the grant, and the denominator would be the period of time from the date of employment until the date of the grant.

Grants for Future Services

If the grant was before the marriage, vests during the marriage, and was for future services, a coverture fraction will determine the marital portion. The numerator is the period of time from the date of marriage until the vesting date, and the denominator is the period of time from the date of the grant until the option vests.

If the grant was during the marriage, vests during the marriage, and was for future services, then the option will be 100% marital. This makes sense because all of the work to which the options relate occurred during the marriage.

If the grant was during the marriage, vests after the divorce, and was for future services, then a coverture fraction will determine the marital portion. The numerator will be the date of grant until the dissolution, and the denominator will be the date of the grant until vesting occurs.

Fractions Are Not Exclusive

The Davidson opinion noted that while trial courts should apply a fraction to determine to what extent the employee stock options or stock retention shares were earned during the marriage, they are not limited to any specific application of the time rule. In other words, the court’s determination should be tailored to the unique facts of each case.[13] For example, the adjustment to one of the fractions applied in Davidson had to do with the fact that the options for past services were granted to the employee in different blocks. The period of “past service” associated with each block only ran from the time of the previously issued grant until the time of the grant. This made sense because the work to which each option block related only extended back to the date of the prior grant.

Valuation and Distribution

Once the time rule fractions are determined, the analysis shifts to how to value the options and distribute them. There are two generally recognized methods. The first method is to determine the present value of the stock options at the time of the dissolution. The Davidson court recognized two approaches to doing so. First, there is the “intrinsic value” method which is the market value of the stock, less the exercise cost of the option and any applicable financing costs.[14] Second, there is the Black-Scholes method which takes into account the option price, the term of the option, the market value of the underlying security, a risk free rate of return, and the underlying volatility of the stock option, in order to come up with a present value for the options.[15]

While the Davidson court did not express a preference for one particular method over another, the “intrinsic value” method could result in significant problems. For example, if on the date of the decree (or other valuation date) the unvested stock options are at a temporary high or low price, one or the other spouse is going to get a windfall when the stock price normalizes after the decree is entered. If that is a downward correction, the owning spouse will not be happy because the options would have been valued artificially high. If the correction is upward, the non-owning spouse will not be happy because the options would have been valued artificially low when the divorce occurred. The post decree correction should not be disregarded in the decree if the work to which the stock options relate occurred during the marriage as a result of the parties’ joint efforts.

Another problem with the intrinsic value method is evident when the stock price is less than the option price. The intrinsic value method would suggest the options are worthless in that situation, but it is not difficult to appreciate why the non-owning spouse might disagree with that, particularly if the stock has the potential to rebound in the future.

The Black-Scholes method, when properly used, goes a long way toward dealing with the problem created by using the “intrinsic value” method. This is because it accounts for volatility in the stock price and risk. But it requires the expertise of an accountant or other expert competent to speak as to the mathematics and assumptions involved in the formula. And, the result of the analysis is only as good as the expert who is applying it. No matter how good they are, it is not always possible to account for unforeseen risks. Think September 11, and the sudden effect it had on the stock market.

The second method for valuation and distribution avoids the present value issues inherent in the intrinsic value and the Black Scholes methods altogether by using a deferred distribution approach. In Davidson, the court recognized this as the “if, as, and when” method and explained that the nonemployee spouse receives his or her share of the value of the options not when the decree is entered, but when the options are actually exercised.[16] In other words, the court need not determine any present value for the options. Rather, it would order the owning spouse to pay the nonowning spouse a stated portion of the profit from the exercise of the options.[17]

It is important to note that when using the deferred distribution method, the non-employee spouse cannot typically be awarded the options outright in the divorce. This is because stock option agreements ordinarily do not permit non-employees to own the stock options, nor do they permit the employee owner to make a transfer incident to divorce. And Qualified Domestic Relations Orders (QDROs) are no help because they do not apply to stock options and cannot create rights that do not otherwise exist with respect to the asset. Therefore, the deferred distribution method is used, the employee spouse will be awarded the stock options subject to the Decree’s provisions that specify the marital and non-marital portions as discussed above.

This predicament can create anxiety for the non-employee spouse. Perhaps, many months after the Decree is entered and after the options vest, the non-employee spouse perceives that circumstances are favorable or desirable for exercising the options. The employee spouse may not agree and may refuse to exercise the options. Or, there may be high conflict between the former spouses, and ulterior motives may exist for exercising or not exercising the stock options. In this situation, the non-owning spouse may want the decree or property settlement agreement to give him or her some degree of control over when and if the marital portion of the options are exercised. This is typically done by using language that provides for a constructive trust that that benefits the non-employee spouse. Additionally, language can be sought that gives the non-employee spouse the power to direct that the employee spouse exercise options on the non-employee’s behalf, and upon notice. Care should be taken to confirm that such an arrangement will not run afoul of the employee’s rights pursuant to the option agreement or plan, and of course, the language of the decree or property settlement should also provide for the court to retain jurisdiction to supervise the deferred distribution.

Tax Considerations

Consultation with a CPA is advisable because employer issued stock options may be incentive stock options (ISOs) or nonqualified stock options (NSOs). A full discussion of the differences in these types of options is beyond the scope of this article, but suffice it to say, in Davidson, the Black/Scholes valuation method used to value the stock options considered the tax consequences of exercising the options. In order for the court to do that, the parties must present evidence of what the tax consequence will be. When doing a deferred distribution method, clients should be advised to consult an appropriate tax professional to provide guidance on the tax consequences of, and any tax planning that should be done in connection with, exercising the options.

[1] 2 Equit. Distrib. Of Property, 3d § 6:48.

[2] Davidson v. Davidson, 254 Neb. 656, 660 (1998).

[3] Brozek v. Brozek, 292 Neb. 681, 695 (2016).

[4] Id.

[5] Davidson, 254 Neb. at 662-63.

[6] Neb. Rev. Stat. § 42-366(8)

[7] Davidson, 254 Neb. at 660.

[8] Id.

[9] Id.

[10] Id.

[11] Id. at 665.

[12] Id.