Stock Options and Restricted Stock
by Wes Cowell, updated 28 August 2015 -- suggest a correction
Stock options are subjection to division between spouses in a divorce. The process can be technical and tricky. Work with a lawyer. Need advice? Call, leave your info, or scheduleschedule a consultation.
Many companies secure the talents of high-level executives and key employees by offering stock options or restricted stock as part of their compensation. Stock options allow the employee to lock in the right to buy stock (exercise the option) at a certain price on or after a certain date. The value of the option is the difference between the “exercise price” and the stock’s fair market price when the option is exercised. Restricted stock is company stock that cannot be transferred (from the company to the employee) until certain conditions (restrictions) are met. The restrictions typically include continued employment for a period of time or achieving performance goals or financial targets. Restricted stock is preferred over stock options due to favorable accounting rules and income tax treatment.
Stock options and restricted stock 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 granted to certain employees as part of a long-term incentive package accomplish one or two things: 1) they may reward past performance and / or 2) they may entice an employee to remain with a company long after he or she might otherwise have left. Basic rules for dividing stock options in divorce:
Options rewarding performance given prior to the marriage, are non-marital property.
Options rewarding performance given during the marriage, is marital property.
Options intended to serve as an incentive for future loyalty and performance, may or may not be marital property. 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.
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?
The Old Law: Illinois divorce law used to make things even worse by requiring the court to value all assets when the trial commenced – an impossible task given the nature of stock options. Until 2002, divorce courts that dealt with stock options 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” – considered 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 took 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. In re: Marriage of Moody, 119 Ill.App.3d 1043, 457 N.E.2d 1023 (1st Dist., 1983). Alternatively, courts would identify the portion of the options characterized as marital property and would rule that a certain percentage of that share of the options had to be paid over to the non-earning (former) spouse upon the exercise of the options. In re: Marriage of Frederick, 218 Ill.App.3d 533, 578 N.E.2d 612 (2d, 1991).
The New Law: Today, Illinois law (750 ILCS 5/503(b)(3)) requires the court to presume that stock options granted during the marriage are marital property "whether vested or non-vested or whether their value is ascertainable . . . ." 750 ILCS 5/503(b)(3). The burden is on the employee spouse to show which options should be characterized as non-marital. The law requires the court to allocate stock options and restricted stock 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. The law says:
The court shall allocate stock options and restricted stock or similar form of benefit between the parties at the time of the judgment of dissolution of marriage . . . recognizing that the value of the stock options and restricted stock or similar form of benefit may not be then determinable and that the actioal diision of the options may not occur until a future date. In making the allocation between the parties, the court shall consider, in addition to the factors set forth in subsection (d) of this Section, the following:
(i) All circumstances underlying the grant of the stock option and restrcited stock or similar form of benefit including but not limited to the vesting schedule, whether the grant was for past, present, or future efforts, whether the grant is designed to promote future performance or employment, or any combination thereof.
(ii) the length of time from the grant of the option to the time the option is exercisable.
See, e.g. In re: Marriage of Isaacs, 260 Ill.App.3d 423, 198 Ill.Dec. 169, 632 N.E.2d 228 (1st Dist., 1994). The law now specifically embraces the “wait-and-see approach,” but still leaves it to the judge to separate the marital options from the non-marital ones.
The first thing to look at is the purpose of the options to determine whether they compensate for past, present, or future compensation or consideration. The ratio of marital-to-non-marital property in stock options is then formulated into 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).
The numerator of the coverture fraction is the number of months from either the date of hire or the date of the options grant until judgment. The denominator usually is the number of months from either the date of hire or the options grant until the exercise of the option. 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 product represents the marital portion of the options.
Other formulas may be used and 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. In re: Marriage of Dunavant, 986 SW2d at 882. Others apply to options ostensibly granted for future loyalty and services but are really compensation for present services. Batra v. Batra, 17 P3d 889 (Idaho, 2001). 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. 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.”
Beyond the allocation analysis, courts must also determine whether a restriction on the sale of stock acquired through exercisingan 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. Persuasive arguments can be made that a restriction on sale is tantamount to a restriction on vesting. Such a ruling would affect the coverture fraction; and that would affect the portion of shares that could be allocated between the spouses.
Constructive Trusts for Allocated, Unexercised Options: Most stock options are non-transferable. Sometimes 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.
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> Transmutation — When "Marital"
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