September 2012 - Invisible Assets — The Problem of Stock Options and Deferred Compensation in Divorces
by Kathleen O. Peterson
The valuation and division of employment-related assets, such as deferred compensation and stock options, present some of the thorniest issues in family law cases. This is because of the relative lack of appellate authority to provide clear-cut rules as well as the need for individualized, factual determinations by the trial court, which often require evidence from employers or business partners in addition to the parties themselves. Further, the particulars of these kinds of compensation are complex and difficult for most people to understand. The result is that cases in which there are significant assets of this type end up being difficult to settle and particularly expensive to litigate.
The Key Legal Principles
Let’s start with the legal propositions for which there is no confusion—assets acquired during the course of a marriage through the efforts of one of the spouses are typically community property. Cal. Fam. Code Ann. § 760 (West 1994). We also know that, in general, if a property division issue is submitted to the court for decision, the court “must effect an equal division of the community estate . . . except as otherwise expressly provided by statute.” Cal. Fam. Code Ann. § 2550. In other words, the court has an obligation to divide the entire estate equally. In order to do this, the court must be able to place some value on all assets, even if they cannot be easily sold or are contingent in nature. If not, the court will have no choice but to reserve judgment on those assets and leave valuation and division to be decided at a later time.
The Key Cases
There are dozens of cases that provide detailed, almost line-item by line-item explanations of how to treat community property interests in most assets that typically are at issue in divorces. See In re Marriage of Moore, 28 Cal. 3d 366 (1980); In re Marriage of Marsden, 130 Cal. App. 3d 426 (1982) (regarding valuation of community interests in a house purchased by one of the spouses before marriage); In re Marriage of Hewitson, 142 Cal. App. 3d 874 (1983); In re Marriage of Ackerman, 146 Cal. App. 4th 191 (2006) (regarding the valuation of good will in a business operated by one of the spouses). However, when it comes to the signing and stay bonuses, phantom stock and options, and complicated future-looking profit rights that many Californians receive as part of their compensation, there are only a handful of cases that are useful. To add to the difficulty, the key teaching of these cases is that it is squarely in the discretion of the trial court to come up with an appropriate way to value these assets.
The two primary cases are In re Marriage of Hug, 154 Cal. App. 3d 780 (1984), and In re Marriage of Nelson, 177 Cal. App. 3d 150 (1986). Hug, the first California case to address the valuation of stock options, involved a series of stock options given to the husband through his employment with Amdahl. The trial court employed a “time rule” to determine the community property interest in the options, which was affirmed by the court of appeal. The court determined that the community interest was a fraction of the husband’s exercisable options: the numerator was time between the commencement of the spouse’s employment and the date of separation, and the denominator was time between the commencement of employment and the date when each option was first exercisable. Thus, if the couple separated four years into the husband’s employment, when the options would first be exercisable after eight years of employment, the community’s share would be one half of the exercisable options. The remaining options would be the husband’s separate property.
A key point in this decision is the Hug court’s use of the date of employment as the date for calculation, rather than the date on which the options were granted. This effectively made a greater portion of the options community property. While stressing that “no single rule or formula is applicable to every dissolution case involving employee stock options,” the court of appeal approved the trial court’s use of the date of employment in this case based on the “substantial evidence” that the employee’s entire period of employment was relevant to the grant of options, and that it was the employer’s intent to both attract him and retain him as an employee. 154 Cal. App. 3d at 790–92. Thus, the employer’s intent in providing this compensation was a key factor.
In Nelson, decided just two years later, the trial court used a different time rule. The Nelson court used the period from the granting of the options to the date of separation/date of exercisability as the proper period. The husband unsuccessfully argued that the options should have no community property component, since the options would only have value based on his and his co-workers’ post-separation efforts. While the court of appeal affirmed the trial court’s calculation, the decision is not a ringing endorsement of this modified time rule on a widespread basis. The court stated: “Our reading of In re Marriage of Hug convinces us that no modification of the trial court’s formula for apportionment is necessary,” noting the Hug court’s statement that no single rule or formula is applicable to every case. Thus, all we really know from Hug and Nelson is that some sort of time rule may be used, depending on the particular facts of the case, including the employer’s intent, but that fine-tuning the rule is left to the discretion of the trial judge.
The breadth of discretion given to trial judges is further demonstrated in In re Marriage of Harrison, 179 Cal. App. 3d 1216 (1986), which followed closely after Nelson. The husband had a mix of qualified and non-qualified options. The court of appeal noted that the time rule used by the trial court was “technically incorrect” because it did not recognize the difference in types of options. Id. at 1224. Nevertheless, the opinion affirmed the trial court’s decision after noting what justices believed the trial court intended to do.
It wasn’t until In re Marriage of Walker, 216 Cal. App. 3d 644 (1989) that a trial court’s calculation of the community interest in stock options was overturned. The appeals court found that the trial court should have used the formula from Harrison, which used the dates the options became vested rather than just exercisable. The Walker court noted the distinction between an ability to exercise an option and an ability to purchase stock received pursuant to the exercise. “The community has an interest in employment benefits conferred during marriage.” Id. at 651. Here, the formula used by the trial court had given the community more than that to which it was entitled.
The difficulties presented by these cases when taken as a whole are legal, practical, and strategic. On the legal side, the difficulty is that it is easy to have legitimate, good-faith disputes over how to characterize the community property interest in these assets and how to value them. This makes it very challenging to resolve these cases through settlement.
On the practical side, the nature of these benefits means that the testimony of experts will likely be required—forensic accountants to calculate the value of the interests, and perhaps compensation experts to explain, in a straightforward manner, how the benefits work. While it is fairly common to use forensic accountants in family law cases, it is less common to need information or evidence from an employer for a retained expert to perform their work.
Further, given the complexity of these kinds of compensation and how closely tied they are to the financial projections and performance of the employer, it is the unusual party/employee who can satisfactorily explain the ins and outs of when he or she will be entitled to receive the benefits, and how they will be paid and held. Thus, it will most likely be necessary to have someone from the employer provide evidence. Many employers are reluctant to get involved in an employee’s divorce, and many opposing spouses are reluctant to depend on the employed spouse to control the information flow from the employer.
The strategic issues go to what the parties should ask of the court and what should happen if the parties are able to reach agreement on the percentage community property interest and valuation. Should the court reserve jurisdiction over these assets and divide them when the options vest and/or are exercised? Should the employed spouse hold the assets in his or her name and simply have an obligation to pay the divorced spouse a certain amount when a liquidation event occurs? Who will pay the taxes and what will those taxes be? These questions are practically very difficult to answer.
The emotional impact of these decisions on the parties must also be considered. For the employed spouse, none of the possibilities are appealing—he or she does not want to hold assets for the benefit of a former spouse (and thus have an ongoing fiduciary duty), but he or she is also opposed to having the former spouse independently hold stock in the employer and obtain detailed information concerning the operations of the business and the former spouse’s employment status and prospects. On the other hand, the non-employee spouse is hesitant to make a decision to keep a significant portion of assets invested in a business in which they have little control or insight, with often limited ability to liquidate the investment. At the same time, he or she worries about cashing out or retaining an interest in the next nascent Facebook or Instagram.
In conclusion, stock options and other types of employee deferred compensation present great challenges in divorce cases, whether they are resolved through trial or settlement. When such assets are a significant portion of a community estate, the attorneys and the parties need to be nimble and persistent in developing the needed evidence; each side should work with the counterpart attorney and party to develop workable paths toward a solution that will work long-term for both spouses.
Kathleen O. Peterson has a practice in Irvine that focuses on family law and business litigation. She can be reached at email@example.com.