by Alexander C. Payne
How does the family court divide and characterize employee benefits and executive compensation plans like stock appreciation rights (SARs), restricted stock, and stock options?
In dissolution, both parties should split the community estate equally. Cal. Fam. Code § 2550. This requires first characterizing an asset as community or separate and then dividing the community asset. The Family Code provides some general framework. The presumption is that property acquired during marriage is community property, and property acquired prior to marriage or after separation is separate property. Cal. Fam. Code §§ 760, 771. However, some assets are far more difficult to characterize and divide.
As an easy example, take income earned during marriage. The parties earned the money during marriage and placed the money into a bank account. At dissolution, the family court can easily determine the money’s character as it was earned during marriage and just as easily divide the money equally between the parties. Unfortunately, the general framework set forth by the Family Code becomes less useful the more complex the asset becomes.
On the more difficult end, take stock appreciation rights (SARs). Employers offer SARs to employees as a form of incentive compensation where employees earn a bonus equal to the appreciation of the employer’s stock over a time period. Each plan may have a vesting period dependent on time, employee performance, employer performance, or all three. Each plan may limit when or how an employee may receive the bonus. Some SARs allow an employee to cash out only upon a specific event, whereas other SARs allow an employee to cash out annually. Almost always, SARs are subject to clawback provisions where the employer may take back all or some of the cash or rights.
To demonstrate the complexities, assume the following facts for our hypothetical: (1) An employer issued the employee-spouse 100 shares of SARs; (2) the SARs vest over a three-year period dependent solely on the employee-spouse meeting future sales goals; (3) the employee-spouse forfeits the SARs automatically upon cessation of employment regardless of vesting; and (4) the employee-spouse cannot cash out the SARs for five years. If the employee-spouse gets divorced two years into the vesting period, how should the court divide and characterize the SARs?
Short answer: any reasonable method may be used to divide and characterize the SARs or any other employee benefit. Marriage of Sonne, 48 Cal. 4th 118 (2010). Long answer: look to the following non-exhaustive key factors: (1) whether the employee has a property right to the benefit or just a mere expectation of a future benefit; (2) the employer’s reasons for providing the benefit; (3) the employee’s efforts that led to the benefit; (4) when the employee’s efforts took place; and (5) as a catch-all, equity.
1. Does the Employee Have a Property Right?
The first step is determining whether the employee-spouse has a property right to the SARs. The Supreme Court’s seminal decision in Marriage of Brown, 15 Cal. 3d 838, 841 (1976), starts our analysis. In Brown, the Supreme Court addressed the allocation of the husband’s unvested pension benefits at divorce. Id. at 841. Under French v. French, 17 Cal. 3d 775, 778 (1941), the trial court held that since the pension rights had not vested, the pension rights constituted a “mere expectancy” rather than property subject to division.
On appeal, the Supreme Court overruled French. The Supreme Court found that a pension is a form of deferred compensation for services rendered pursuant to a contract. Marriage of Brown, 15 Cal. 3d at 845. These contractual rights are a form of property. In comparison, a mere expectancy is an “interest of a person who merely foresees that he might receive a future benefice, such as the interest of an heir apparent” or insurance beneficiary. Id. at 844-45.
In returning to our SARs hypothetical, does the employee-spouse have an enforceable right to the SARs? On one hand, there is a contract with a vesting schedule. On the other hand, the employer could terminate the employee for any reason and the employee has a right to nothing.
2. The Time Rule
In going back to Brown, assuming the court characterizes a pension or benefit as community property, the court must divide the pension rights between parties. Courts generally apply the time rule, which apportions the pension benefit (i.e., when the benefit is paid) by a ratio of the years of service during marriage and the total years of qualifying employment. An employee spouse who worked for ten years and had a five-year marriage would have the benefit divided 50% to the community because the community contributed for half of the length of employment.
The time rule works well with pension rights because the community owns “all pension rights attributable to employment during the marriage.” Id. at 844. However, for the same reason, the application of the time rule should be limited to situations where the benefit is substantially related to the years of service or at the very least, “representative of the relative contributions of the community and separate estates.” Marriage of Lehman, 18 Cal. 4th 169, 187 (1998).)
The Supreme Court noted that courts could alternatively value the community’s pension rights at divorce rather than apportion the benefits when paid under the time rule. Brown, 15 Cal. 3d at 848. When determining the present value, the court “must take account of the possibility that death or termination of employment may destroy those rights before they mature.” Id.
In returning to our SARs hypothetical, assuming we characterized the SARs as community or separate or a combination of the two, the time rule seems inappropriate because the length of the employee-spouse’s service is not controlling. The vesting depends on the employee-spouse’s meeting sales goals. Alternatively, valuing the SARs may be impossible or result in a zero value because the employee-spouse may be terminated or leave employment at any time, and the employee-spouse cannot cash out for a significant time period. As such, Brown does not fully answer our hypothetical.
3. Developing the Time Rule Beyond Pensions and Looking to Qualitative Factors
After Brown, pensions became less commonplace. Employers found new and more creative ways to provide benefits to keep up with tax law changes and economic conditions. For example, in 1973, stock options were listed on U.S. exchanges, and in 1977, the SEC allowed the trading of put options (an option to sell stock at a specific price on or before a specific date).
In the 1980s, these highly compensated employees started to get divorced, and case law developed on how to divide and characterize stock options at divorce. See e.g., Marriage of Harrison, 179 Cal. App. 3d 1216 (1986); Marriage of Nelson, 177 Cal. App. 3d 150 (1986); Marriage of Hug, 154 Cal. App. 3d 780 (1984).) No case law on stock options existed, so the courts borrowed the analysis and time rule from Brown. However, Harrison, Nelson, and Hug developed the time rule and universally stressed the no single method existed.
First, in Hug, the court of appeal upheld the trial court looking at the employer’s reasons for offering the stock options as a basis to apportion the stock options. Prior to separation, the husband received stock options, which became exercisable after the date of separation. Hug, 154 Cal. App. 3d at 782. The trial court measured the time from the husband’s date of hire rather than the date the employer granted the stock options because the husband received less initial salary to later obtain stock options. Id. at 789. The community should receive the additional years measured from the date of hire because the community received less salary during marriage. Id.
The court of appeal explained that, “Benefits may be a function of longevity or time, or of the nature or frequency of services rendered” or “on the purposes for which they were created.” Id. at 788. The court of appeal alternatively noted that “equity could require a determination that stock options are solely property of the employee spouse” or that options granted after separation may have a community component. Id. at 793.
Second, in Nelson, the court of appeal addressed the same material facts where prior to separation, the husband received stock options, which became exercisable after the date of separation. Nelson, 177 Cal. App. 3d at 153. Unlike the Hug court, the trial court apportioned the stock by a time rule measured by the date of grant rather than date of hire. Id. at 155. While Nelson presents the most commonly applied method and Hug is often limited to its facts, the analysis in Hug is helpful, and the contrast between the two opinions demonstrates the wide discretion afforded to trial courts in characterizing and dividing benefits.
Finally, in Harrison, the court of appeal again addressed the same material facts except that some stock was restricted stock. Harrison, 179 Cal. App. 3d at 1224. In general terms, restricted stock is generally stock issued to an employee, subject to restrictions on transfer. The restricted stock may be subject to vesting dependent on time, employee performance, employer performance, or all three, and may even be valueless except if the employer is acquired. Restricted stock may be subject to clawback provisions, where the employer may take back all or some of the stock. In Harrison, the restricted stock had a clawback provision where an employee forfeited the restricted stock if the employee was terminated for cause or left without the employer’s consent. Id. Unlike Hug and Nelson, the trial court measured the time to the date the restrictions fell off rather than to the vesting date for exercising the option. Id. at 1225.
All three stock option cases, Hug, Nelson, and Harrison, show the broad discretion afforded to the trial court in dividing and characterizing employee benefits; there are many factors courts may consider. Going back to our example with the SARs, Hug tells us to look to (1) the employer’s reasoning in granting the SARs; and (2) equity. Harrison tells us that even though the SARs are subject to forfeiture, the community may have an interest. Hug and Nelson tell us that even under the same plan documents, courts can come up with different methods of allocation. More development is clearly needed.
4. Evolving Compensation Structures and Tax Changes Limit the Time Rule’s Applicability
Since the 1980s, stock options became less popular as the economy evolved and tax laws changed. For example, in 2006, Generally Accepted Accounting Principles (GAAP) required stock options to be characterized as an expense in an employer’s income statement. The change meant that stock options were characterized as compensation along with the employee’s salary. As a result, employers looked less profitable. In 2008, the economic crisis led to the Dodd-Frank Act, which led to an increase in performance-based compensation and a decrease in stock options.
The number of performance-based compensation plans is seemingly limitless and growing. To name a few, there are SARs, restricted stock, phantom stock, restricted stock units (RSUs), employee stock purchase plans (ESPPs), restricted cash awards, forgivable loans, and stock options. The appellate courts have addressed a few of these benefits generally and given some guidance, but each employer’s plan varies significantly, and what is equitable in one case may not be in another. For example, as discussed, the Hug time rule differs from the Nelson time rule.
The court of appeal’s analysis in Marriage of Finby, 222 Cal. App. 4th 977 (2013), shows how the foregoing principles can work together in characterizing and allocating modern performance-based benefits. In Finby, prior to separation, the wife received multiple cash bonuses for transferring from UBS Financial Services to Wachovia/Wells Fargo.
For the first bonus, the wife had to repay the bonus if she was not continually employed by Wells Fargo for six years, which was several years after the parties separated. Id. at 983, 990. The court of appeal determined that the bonus, despite receipt during marriage, constituted a “mere expectancy” rather than a property right, citing Brown, 15 Cal. 3d at 845, because the wife had “no enforceable right” to receive the bonus. This analysis seems at odds with Harrison, where the restricted stock had the same conditions for forfeiture.
For the second and third bonuses, the wife received bonuses prior to separation as an incentive to transfer to Wells Fargo and bring her book of business to Wells Fargo, which would have partially occurred post-separation. Id. at 990-91. Unlike the first bonus, the court of appeal found a community interest because the second and third bonuses were partially earned prior to separation as wife developed her book of business during marriage. Id. at 991. This conclusion seems to support Hug’s analysis in looking to the employer’s reasoning. In doing so, this conclusion seems to simultaneously undercut Family Code section 771, because income earned post-separation should be the wife’s separate property.
Although the court of appeal characterized the second and third bonuses, the allocation remains a mystery as the matter was remanded back to the trial court to apportion the bonuses. The court of appeal directed the trial court to “evaluate the potential wife may fail to satisfy the conditions required to retain the advances received by her.” Id. At that point, the trial court can determine the method to divide the second and third bonuses.
Let’s return to our SARs hypothetical. On one hand, under Finby, the employee-spouse seemingly has “no enforceable right” to receive the SARs because it depends on meeting sales goals and continued employment through vesting. On the other hand, Harrison had a similar forfeiture provision and the court of appeal found a property right to the restricted stock and options. At the same time, SARs are a form of deferred compensation under Brown and future incentive compensation under Finby—both a community and separate component.
5. Any Reasonable Method
Due to these complexities, seeming contradictions, endless factors, and the underlying need to do equity, family courts must have tremendous discretion to allocate and characterize assets. The formula courts choose to apply to apportion employment benefits remains an open-ended question. Any reasonable method is appropriate. Marriage of Sonne, 48 Cal. 4th 118 (2010). This may mean that the SARs could be 100% separate property or 100% community property, a combination of both, or not property at all.
Alexander C. Payne is a family law attorney at Minyard Morris, and OCAABA Director and Committee Chair. He can be reached at email@example.com.