Stock Options and Divorce
Many companies secure the talents of high-level executives by offering stock options as part of their compensation. The employee, without investing anything, locks in the right to receive the value of the option. That value is the difference between the “exercise price” and the stock’s fair market price at the time the option is exercised.
Stock options present two problems in a divorce case. The first problem is determining how much of a stock option is marital property and how much is non-marital property. Stock options are granted to certain employees as part of a long-term incentive package designed to accomplish one or two things: 1) they may reward past performance, and / or 2) they may be used to entice executives to remain with a company long after he or she might otherwise have opted to leave. The portion of options that reward past performance made prior to the marriage, is non-marital property. The portion of options that reward for past performance made during the marriage, is marital property. The portion of may or may not be marital property. That is, the “enticement” portion that will outlast the marriage probably belongs to the employee-spouse as non-marital property and should not be divisible in a divorce. How can one know how much of an option is given for each purpose? How are divorce lawyers and judges to determine the marital portion of any given stock option?
The second problem is that no one really knows the true value of a stock option until it is exercised – and that may not be until many years after the divorce is finalized. How can we determine today the value of an asset which, by definition, cannot be valued until some future date?
Illinois divorce law used to made things even worse by requiring the court to value all assets at the time the divorce trial commenced – a seemingly impossible task given the nature of stock options. Up until 2002, divorce courts that dealt with stock options courts relied on valuation models used in tax cases. Those models, designed to reflect market forces when valuing marketable stock options, proved cumbersome and inappropriate tools for the family law courts. One common model, the “Black-Scholes model” – took into account the stock price, the exercise price, the maturity date, the prevailing interest rates, the volatility of the company’s stock, and dividend rate. The court would have to hear testimony from several executives from the corporation and several economists before it could make any findings.
Out of necessity, Illinois divorce courts began to take a “wait-and-see” approach (contrary to the law’s requirement that assets be valued as of the commencement of the trial). The court would grant the divorce but would retain jurisdiction over the parties to ensure a fair division of the proceeds resulting from the exercise of stock options, if and when they were ever exercised.1 Alternatively, courts would identify the portion of the options that were “marital” in nature (as opposed to non-marital) and would rule that a certain percentage of the proceeds from that share of the options had to be paid over to the non-earning (former) spouse upon the exercise of the options.2
As of 1 January 2002, Illinois divorce law requires the court to presume that stock options granted during the marriage are marital property and specifically requires the court to allocate stock options between the parties at the time of the judgment even though the value of the options might not be known and the options themselves might not be divisible until a future date.3 In other words, the law now specifically embraces the “wait-and-see approach,” but still fails to define formula or rule that separates the marital options from the non-marital ones.
So, divorce lawyers have to help the court understand the extent to which the options were granted for past, present, or future compensation. Stock options that are compensation for services rendered prior to the marriage should be found to be the non-marital asset of the employee spouse. Options that are compensation for services rendered during the marriage should (probably) be found to be marital property and allocated between the spouses. Options that are compensation for future services (or other consideration – like staying with the company for a number of years rather than joining or starting a competing enterprise) should (probably) be found to be the non-marital property of the employee spouse.
Coverture Factions: Illinois law requires the court to presume that all stock options granted during the marriage are “marital property.” That means that the burden is on the employee spouse (and his or her attorney) to show the court which options should be considered marital and which should be found to be non-marital. That’s not always easy. The first thing to look at is the purpose of the options – as described above – to determine whether they compensate for past, present, or future compensation or consideration. For all options that compensate for services rendered (or consideration given) during the marriage, the lawyer must show the portion of that option that is actually marital property. To do this, divorce courts usually rely on a “coverture fraction” or formula (“coverture” is an ancient legal term that refers to the legal status of a married woman under her husband’s protection and authority).
There are many ways to formulate a coverture fraction. Generally, the numerator is the number of months from either the date of hire or the date of the options grant until the date of the divorce judgment. The denominator usually is the number of months from either the date of hire or the options grant until the date of exercise. The dates used will reflect either a “front-loaded” options package that compensates for past and present services, or a “back-loaded” options package, that is more designed to entice an employee to stay with the company. Whichever dates are used, the resulting fraction is then multiplied by the number of shares the employee spouse may purchase on the exercise date. The resulting product represents the marital portion of the options.
Other formulas may be used and, indeed, the individual grants may also be considered on a case-by-case basis. Some formulas apply to options granted prior to the marriage that vest during the marriage,4 and others apply to options ostensibly granted for future loyalty and services but which, in fact, are compensation for present services.5 Still other formulas exist for allocating stock options subject to staggered vesting. The separately vesting options (known as “flights”) are allocated on an annual, per-flight basis.6 There is no formula spelled out in Illinois law, nor is there any law requiring courts to use coverture fractions. In one noted case, the court said “[we] are not limited to this formula in seeking to achieve an equitable allocation of [marital and non-marital] interests... reference to the facts of each particular case must be made to reveal the features and implications of a particular employee stock option.” Call our office to talk with a knowledgeable, experienced attorney to find the right formula for your case.
Beyond the allocation analysis, courts must also determine whether a restriction on the sale of stock acquired through the exercise of an option operates as part of the vesting of the option. At least one court has held that a restriction on sale does not impact the ownership of the stock and, therefore, its characterization as either marital or non-marital property. On the other hand, persuasive arguments can be made that a restriction on sale is tantamount to a restriction on vesting. Such a ruling would move the coverture fraction; and that would affect the portion of shares that could be allocated between the spouses, or solely assigned to the employee spouse. Again, if you have a “vesting-with-restriction-on-sale” issue, call our office to work with one of our attorneys.
Constructive Trusts for Allocated, Unexercised Options: Most stock options are non-transferable. In some cases, the court leaves the decisions of whether or not to exercise an option to the discretion of the employee spouse. An irrational or vindictive employee spouse -- simply to deprive the non-employee spouse of income -- might choose to forego profit and refuse to exercise vested stock options. Illinois divorce law permits the court to create a constructive trust that would require the employee spouse to exercise the options at the election of the non-employee spouse. There are other, less draconian resolutions to the “vindictive spouse” problem. Call our office to learn more.