RSUs, ISOs and Other Options

Courts have held, in general, that if you were granted stock options or RSUs prior to marriage, but they exercised during marriage OR if you were granted stock options or RSUs during marriage that vest after separation, the court will apportion these stocks between community and separate property based on how long you were married and working during the exercisable period.

Time Rule Formulas

Court Cases

The marriage of Hug was the first case in California that judged the Separate Property and Community Property characteristics of stock options.  In re Marriage of Hug, 154 Cal.App.3d at p. 792.

Hug specifically states, "we stress that no single rule or formula is applicable to every dissolution case involving employee stock options. Trial courts should be vested with broad discretion to fashion approaches which will achieve the most equitable results under the facts of each case."

In the marriage of Hug the actual purpose of the stock options were deemed critical in determining the formula for the division of Community Property and Separate Property.  In re Marriage of Hug, supra, 154 Cal.App.3d at p. 785.

Treatises which describe employee stock options in the context of general corporations law strongly suggest that contractual rights to such benefits vary so widely as to preclude the accuracy of any but the most general characterization of them. Thus, there is no compelling reason to require that employee stock options must always be classified as compensation exclusively for past, present, or future services. Rather, since the purposes underlying stock options differ, reference to the facts of each particular case must be made to reveal the features and implications of a particular employee stock option.

In both the Hug case and the Nelson case, dates of vesting and exercisability coincided exactly.  In the instance of the current company dates of vesting and dates of exercisability are different.  This coincidence of vesting and exercisability is an important point because in the case of Hug and of Nelson, the awarded options became immediately available for transaction and thus were immediately valuable to the employees at the time the stock vested.  

The court in Hug acknowledged that stock options are often awarded to executives to provide alternative compensation.  In re Marriage of Hug, supra, 154 Cal.App.3d at p. 785.

Along with the general goal of structuring compensation favorably, other purposes accompany various benefit plans. "Bonus and profit-sharing arrangements may take various forms such as a stock purchase option for a certain period, a management stock-purchase plan, or an employees' stock purchase plan. The primary purpose of a company stock-option plan is the attraction and retention of executive, key or qualified personnel, and the granting of such option is considered a form of compensation . . . . The purchase of shares by the executive officers in connection with an employee stock-purchase plan which may give the privilege of obtaining shares on a large scale at less than the market price often amounts to a lucrative bonus." (5 Fletcher, op. cit. supra, § 2143.1, at p. 551.) A number of factors may prompt companies to use such alternatives, among them management's wish for a direct share in company profits, the possibility of increasing management's incentive and efforts, cutting taxes and providing security for the executive. (1 Washington & Rothschild, op. ct. supra, at p. 30.)

Courts have held that a time rule is used in allocating such interests between community and separate property of such options.   Courts have also found that there is no single formula appropriate for dissolution cases.  There are cases that directly addressed the different dates of vesting and exercisability, notably, “Walker” and “Harrison” and these analyses are included for consideration.

Distinguishing the cases

This case is distinguished from Nelson case in that Ampex, the stock in Nelson, was publicly traded on the American stock exchange at the time it was earned by Harold Nelson. Ampex began trading stock publicly in 1953, when annual sales were $3.5 million.  There was a fair market value attached to the stock.  The San Mateo Court did not distinguish between vested and exercisability in the case of Nelson because vesting happened at the same time the stock was exercisable. 

Contrast this with this case where the stock that was earned was vested years before it was exercisable because this company was not publicly traded when vested, thus had no objective Fair Market Value at the time it was vested. 

HUG

In re Marriage of Hug, 154 Cal. App. 3d 780 April 20, 1984  the court found "the number of options determined to be community property is a product of a fraction in which the numerator is the period in months between the commencement of the spouse's employment by the employer and the date of separation of the parties, and the denominator is the period in months between commencement of employment and the date when each option is first exercisable, multiplied by the number of shares which can be purchased on the date the option is first exercisable. The remaining options are the separate property of the employee." (Id., at pp. 782-783.)

“In this case we hold that in marital dissolution actions the trial court has broad discretion to select an equitable method of allocating community and separate property interests in stock options granted prior to the date of separation of the parties, which became exercisable after the date of separation… we stress that no single rule or formula is applicable to every dissolution case involving employee stock options. Trial courts should be vested with broad discretion to fashion approaches which will achieve the most equitable results under the facts of each case.” (Id., at pp. 782-783.)

NELSON

In re Marriage of Nelson, 177 Cal. App. 3d 150 February 4, 1986 the court place[d] more emphasis on the period following each grant to the date of separation . . . than on the employee's entire tenure with the company up to the time of separation . . . ." (Id., at p. 155, fn. 4.) As a result, the Nelson court approved "a formula in which the numerator was the number of months from the date of grant of each block of options to the date of the couple's separation, while the denominator was the period from the time of each grant to its date of exercisability." (Id., at p. 155.) 

HARRISON

In re Marriage of Harrison, 179 Cal. App. 3d 1216 April 18, 1986 [The court] found the appropriate method of determining the community property interest was to create a fraction, the numerator of which is the total number of days between the signing or granting of the option agreement and the date of separation and the denominator of which is the total number of days between the signing or granting of the option agreement and the day on which each portion of the stock received pursuant to the exercise of the option became fully vested and not subject to divestment. This fraction is then multiplied by the gain on the stock option on the date of exercise. (Id., at pp. 1223-1225.)

WALKER

In re Marriage of Walker, 216 Cal. App. 3d 644 December 13, 1989 Considerations of exercisability of the options and vesting of the stocks are, however, extremely significant.  As discussed above, Harrison recognized the distinction between the ability to exercise an option and the ability to purchase the stock received pursuant to the exercise of the option. To ignore this difference is to misconstrue the entire time rule concept. The community has an interest in employment benefits conferred during marriage. (Id., at pp. 1223-1225.)

Brown

The community has an interest in employment benefits conferred during marriage. In In re Marriage of Brown (1976) 15 Cal.3d 838, our Supreme Court acknowledged the community does not lose its interest in those benefits simply because they are received after separation. Conversely, however, when the parties separate before the benefits are vested, the community does not receive all of them. There must be an allocation taking into account the periods of time before and after separation.

Applying (Hug and above cases)

At the most general level, employment benefits such as stock options may be classified as an alternative to fixed salaries to secure optimal tax treatment. In this sense, stock options fall into the same category as, for example, fringe benefits, health and welfare benefits, incentive compensation based on company profits, deferred compensation plans, and pension and profit-sharing arrangements.

Bonus and profit-sharing arrangements may take various forms such as a stock purchase option for a certain period, a management stock-purchase plan, or an employees' stock purchase plan. The primary purpose of a company stock-option plan is the attraction and retention of executive, key or qualified personnel, and the granting of such option is considered a form of compensation . . . . The purchase of shares by the executive officers in connection with an employee stock-purchase plan which may give the privilege of obtaining shares on a large scale at less than the market price often amounts to a lucrative bonus."  A number of factors may prompt companies to use such alternatives, among them management's wish for a direct share in company profits, the possibility of increasing management's incentive and efforts, cutting taxes and providing security for the executive.

If any of the various purposes of stock option plans can be said to bear emphasis, it is probably that of providing incentive. "One of the most widespread programs for providing employees with additional incentive and creating an identification of interest between the company and the key employees is a stock option plan." "Share options are a form of incentive compensation based on the idea that good management results in higher prices which render the share option valuable."

"For the smaller company, for the company without substantial cash resources, for the company in distressed circumstances, stock options may provide a means of attracting strong management willing to render its services for modest current compensation in return for substantial future rewards on a tax-favored basis."

Finally, stock options may be used as additional compensation, even for past services, so long as to meet reasonable expectations as to such compensation which existed while the employee rendered the services. Also, although out of keeping with common business practice, companies frequently provide rewards or bonuses for past services.

In In re Marriage of Brown, 15 Cal.3d 838, the court recognized that contractual rights to future benefits, though unvested and contingent, are property subject to allocation between community and separate interests.

The trial court should exercise its discretion to fashion an equitable allocation of separate and community interests in employee stock options exercisable by the employee spouse after the date of  separation of the parties.

In re Marriage of Nelson

“A large portion of the trial court's decree involved the characterization and apportionment of stock options issued to Harold by his employer, the Ampex Corporation. 1Link to the text of the note These fell into three separate categories: those [***2]  that were granted and became exercisable before the parties separated; those that were granted before the parties separated but were not exercisable until after they separated (hereafter the intermediate options); and those that were granted after the parties separated (hereafter the postseparation options). The first group was characterized by the trial court as wholly community property, the second partly community property and partly Harold's separate property (using a time rule) and the third wholly Harold's separate property.”

Like the previous option grants, the purchase price of each option was the fair market value of Ampex stock on the date of the grant;

Reporter  177 Cal. App. 3d 150 * | 222 Cal. Rptr. 790 ** | 1986 Cal. App. LEXIS 2536 ***Superior Court of San Mateo County, No. 223164, V. Gene McDonald, Judge.

In re Marriage of Walker, 216 Cal. App. 3d 6444th District Court of Appeal December 13, 1989

The Court of Appeal recalculated the community and separate property shares of the options exercised after separation and the community and separate property shares of the options that had not yet been exercised; as modified, the court affirmed the judgment. The court held that the trial court erred in relying on the dates the options were exercisable rather than on the dates the stocks became vested. The trial court should have applied a formula under which a fraction is created, the numerator of which is the total number of days between the signing or granting of the option agreement and the date of separation, and the denominator of which is the total number of days between the signing or granting of the option agreement and the day on which each portion of the stock received pursuant to the exercise of the option became fully vested and not subject to divestment. This fraction is then multiplied by the gain on the stock option on the date of exercise.

In re Marriage of Harrison Court of Appeal of California, Fourth Appellate District, Division One  April 18, 1986

[Katherine's] share is to be obtained by creating a fraction, the numerator of which will be the total number of days between the signing or granting of the option agreement and the date of separation, the denominator of which will be the total number of days from the signing or granting of the option agreement and the day on which each portion of the option became fully vested and not subject to divestment. The ratio created by such fraction will be divided into the gain on the stock option on the date of exercise to determine the community property interest therein after reimbursement for the purchase of the option and any taxes paid by [Eugene] thereon in connection with the exercise of the option. All remaining interest in any stock option agreement not a part of this said ratio is confirmed as the sole and separate property of [Eugene]. [para. ]

Chen v. Chen, 142 Wis. 2d 7

And, in a non-California case, the court found that “Although certain stock options were not exercisable until after the time of the divorce, they were nonetheless an economic resource acquired during the marriage.”

Chen v. Chen, 142 Wis. 2d 7

The husband's employer granted stock options to him during the marriage. They were not exercisable until after the divorce. The options enabled the husband to purchase his employer's stock at a fixed price at certain intervals, regardless of market prices. The divorce judgment provided that all of the stock options, both accrued and non-accrued, were to be included in the marital estate subject to division. Ultimately, the husband was to pay the wife one-half of his net profit. On appeal, the court concluded that the judgment was fair. The inclusion of the options in the marital estate did not improperly award the wife an interest in the husband's future endeavors. The mere fact that the interest in the asset was contingent did not require its exclusion from the marital estate. The trial court properly included the stock options, both accrued and non-accrued, in the marital estate. Although certain stock options were not exercisable until after the time of the divorce, they were nonetheless an economic resource acquired during the marriage.

The stock options were granted during the marriage, but are not exercisable until dates occurring after the divorce. At the time of the divorce, Steve owned various stock options granted by Cray. The option agreements enabled Steve to purchase Cray stock at a fixed price at certain intervals, regardless of market prices. Steve had satisfied the service requirements for some of the options, but others remained non-accrued, that is, unavailable pending completion of additional service requirements. A portion of the options could not be exercised until dates occurring after the divorce. The options, which may be exercised until 1990, may not be transferred or assigned. Also, the options expire if Steve's employment terminates for any reason other than death or disability.

The divorce judgment provided that all of the stock options, both accrued and non-accrued, were to be included in the marital estate subject to division. It allowed Steve to exercise the options if and when he desired, subject only to Cray and Security and Exchange Commission regulations. Ultimately, Steve is to pay Lushiang one-half of his net profit.

Steve seeks to exclude from the marital estate those options that were granted during the marriage but are unexercisable until after the divorce. He claims that the inclusion of those options in the marital estate improperly awards Lushiang an interest in his future endeavors. We disagree.

The trial court heard expert testimony that the present value of the stock options at the date of the divorce was impossible to determine. It rejected the testimony of Steve's expert as to present value. The weight and credibility to be accorded testimony is a trial court function. Thus, the trial court's finding that no present value can be determined is sustained on appeal.

The court considered that the options must be exercised or would expire within the next few years. It observed "[t]he fact that Mr. Chen must work another two-and-one-half to three-and-one-half years for Cray Research does not constitute such a significant factor in the value of these options that they must be excluded from or discounted in the marital estate." The trial court considered SEC regulations, the fluctuations of the stock's price, Cray's sequential exercise restrictions, and tax consequences relative to the exercise of qualified or nonqualified stock options.

The trial court also considered the cost of the funds used to purchase the stock, as well as the tax rates. The trial court concluded that because no reasonably accurate present value can be assigned to the stock options, no award of a fixed sum would be practical. However, the court concluded that the stock options must be included in the marital estate.

Generally, all of the parties' property at the date of divorce, except that derived through gift or inheritance, is subject to division. Whether the asset is characterized as vested, unvested, or a future interest is a factor to be considered in the property division. The mere fact that the interest in the asset is contingent does not mean that it may be ignored.

The trial court properly included the stock options, both accrued and non-accrued, in the marital estate. Although certain stock options are not exercisable until after the time of the divorce, they are nonetheless an economic resource acquired during the marriage. Generally, these stock options are given to key employees to motivate them to remain as employees and to increase efficiency and performance. A stock option contract, like an unvested pension, is not a mere gratuity, but an enforceable contract right. It is an economic resource, comparable to pensions and other employee benefits, and thus a form of property. Although Steve's stock options are unassignable and unsalable, these are factors that relate to the issues of valuation and division.

Steve also contends that those options granted prior to the divorce, but after the parties separated, must be excluded from the marital estate. The marital estate is not to be limited to assets in existence at the time of the parties' separation, but is to include assets as they exist at the time of the divorce. Consequently, we find no merit to this argument.

Finally, Steve argues that the trial court improperly divided the stock options. Steve does not challenge that Lushiang is entitled to one-half of the marital estate. Rather, he contends that if the stock options are included in the marital estate we should adopt a method of division to reflect their nature as partly marital and partly separate property. He suggests a "time-rule" formula to separate out the portions of the options attributable to his post-divorce efforts. Although we approve of the use of a formula, we conclude that it is not mandatory for the trial court to use this formula in order to properly exercise its discretion in dividing the unexercised stock options.

A "time-rule" formula has been adopted in some jurisdictions. In California, one such formula provided that the unexercised stock options that were subject to division were

the product of a fraction whose numerator is the length of service expressed in months by respondent . . . from the date of commencement of service to the date of separation of the parties and the denominator is the length of service expressed in months from the date of commencement of service  to the date when an option could be first exercised, multiplied by the number of shares that could be purchased on the date of exercise.  Hug v. Hug, 201 Cal. Rptr. 676, 679 (Ct. App. 1984). 1

While approving the use of this formula, the Hug court stressed that "the trial courts, in the exercise of their discretion, are not limited to this formula . . . ." Id. at 678. Rather, "the trial court should exercise its discretion to fashion an equitable allocation of separate and community interests in employee stock options . . . ." Id. at 685.

If you need assistance, please contact Annette Brown, CDFA at 415-312-1987 or at msannettebrown@gmail.com