Stock Options in Divorce: Assets or Income?
Should stock options be classified as an asset for equitable distribution purposes in a divorce case or qualified as an income stream for alimony and child support purposes? As stock options become a central means of incentives for many executives around the country, this question has become crucial in divorce cases. As artfully and succinctly stated by Judge Altenbernd of the Second District Court of Appeal,
The difficulty with options in a dissolution proceeding is that they have a dual nature. They have characteristics of an asset in that they represent a right to purchase an ownership share in the underlying corporation’s stock. Under some circumstances, they can be alienable. On the other hand, they have characteristics of income in that the whole purpose behind options is to allow the owner to capture the appreciation in value of the stock prior to its actual purchase. They are usually exercisable over time. Options are often designed to be exercised immediately, not held over the long term. Also, they are often given as a form of compensation. Complicating their nature even further, if an option is given as compensation, it can be deferred compensation for past services, compensation for present services, or compensation for future services.1
This article will discuss the arguments for both classifications and, like many things in life, conclude that the appropriate classification depends directly on the facts of the option and the relief the divorce court is attempting to achieve.
The Chicago Board Options Exchange (CBOE) opened April 26, 1973, with only a few options trading on the Exchange. Today, there are over 1,900 underlying securities (or parent stocks) measured by 60 indices and measuring nearly 300 million option contracts traded. While options perhaps have the reputation of being reckless investments, 70 percent make money, with only 30 percent expiring worthless.
An option is a derivative security; it derives its value from an underlying stock. It is a contract for a right to buy (call) or sell (put) and, like most contracts, the value of the option depends directly on the terms of the option. Electing to buy or sell is called “exercising the option,” which must be done before expiration date. If the underlying security is publicly traded, the option is public and has a specified expiration date which, for control purposes, is the third Friday of any one month. Most public options have an average life of about five months. If the underlying security is closely held, the expiration date would be stated in the contract.
Options are classified according to three types, all of which are a function of the ability to exercise the option. The American option can be exercised at any time; the European option can be exercised only at the expiration date; the Capped option can be exercised only during a specified period stated in the contract.
As the chart in the following exhibit shows, the values of calls and puts tend to rise and fall opposite each other as a function of the factors making up the option. This is true, except in two important circumstances: when the volatility of the underlying security increases or the time to maturity of the option increases. As either of these factors increase, the value of both the call and the put tend to increase.
Measurement of Stock Options
There are a number of models that can be used to value stock options but they all rely on the intrinsic value of the underlying stock and the time delay to exercise the option. Models can be broken into economic models or theoretical models. Under economic models, there is the Shelton model, which focuses on long-term warrants and empirical adjustment factors. The Kassouf model focuses on regression analysis. The theoretical models include the original Black-Scholes model, originating in 1973 and modified by the Merton model, and the Noreen-Wolfson model. The Binomial model further supported these models in 1979. The Black-Scholes model is most commonly accepted and widely used. It relies on the stock price, the exercise price, the risk-free rate, the time until maturity, and the volatility of the underlying stock. The Merton model assumed all the factors of Black-Scholes and added a factor for dividends.
There are critical underlying assumptions to these theoretical models, including the following:
• The underlying stock is freely traded;
• The underlying stock has a constant variance rate of return;
• The underlying stock follows a random walk and is lognormally distributed (efficient market);
• The option is European (exercised only at expiration);
• The investors can borrow and lend at risk-free rates;
• There are no outside factors (such as taxes, commissions, or other transaction costs);
• The underlying stock does not pay dividends for the Black-Scholes model; the Merton model considers dividends.
In spite of these underlying limitations, the Black-Scholes model (specifically the Noreen-Wolfson version) has been documented to have an accuracy factor within six percent.2
Economics of the Option
In 1998, options that were granted comprised two percent of corporate equity. For 1998 and prior, options which are still alive comprise some 20 percent of corporate equity, or over $1 trillion.3 C orrespondingly, the Standard & Poors 500 profits have doubled in 1998 from that of 1990. Does this mean that stock options, in fact, do favorably affect agency theory (the ability to work harder by owning a piece of the rock)? As stated previously, we know that stock options to be classified as compensation and thus expense must be based on measurable performance. If there is no measurable performance, the stock option cost is not charged to expense for accounting purposes. We also know from economics that executives in the decision-making process can raise dividends and benefit all existing shareholders, which excludes option holders, and that such dividends, in fact, lower the value of the underlying stock. This lowered value also lowers the value of the corresponding call. While raising dividends may benefit existing shareholders, it doesn’t do very much for the executive who may hold considerable options not yet exercised.
There is another approach. Executives in power can buy back existing stock (treasury stock) and if this is done with borrowings, the value of the underlying stock will go up. This, of course, will benefit existing shareholders and further will increase the value of the call, thus benefiting the executive who holds unexercised options. If these options, in fact, are not tied to performance, there is no expense charged to the financial statements. According to Fenn & Liang, and based on their study of 1,100 nonfinancial firms during 1993 thru 19974 : “We find a strong negative relationship between dividends and management stock options, as predicted by Lambert, Lannen & Larcker (1989) and a positive relationship between re-purchases and management stock options. Our results suggest that the growth in stock options may help to explain the rise in re-purchases at the expense of dividends.”
Further, a study by Smithers & Co. in 19985 m aintains that corporate profits have been overstated by 50 percent due to the nonrecording of options as an expense. According to Smithers & Co., if share option schemes had been expensed, corporate profits would have declined from the previous year.6
Warren Buffett, in a recent annual report of his investment company, Berkshire Hathaway, said, “Accounting principles offer management a choice: pay employees in one form and count the cost, or pay them in another form and ignore the cost. Small wonder then that the use of options has mushroomed. . . . If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”7
When examining stock options for valuation purposes, most courts have begun by looking at two main questions: 1) Is the option vested or unvested? and 2) Was the option granted for work performed in the past or for work to be performed in the future?
Case Law and Valuation Approaches
Florida’s equitable distribution statute provides that “Marital assets and liabilities include. . . . Assets acquired. . . during the marriage” and “All vested and unvested benefits, rights, and funds accrued during the marriage in retirement, pension, profit-sharing, annuity, deferred compensation and insurance plans and programs.”8 The Fifth, Fourth, and First district courts of appeal have held that stock options, if marital, are subject to equitable distribution.9 It appears from a recent Second District opinion that options may be treated as marital assets, but that it is not error to treat them as income to determine alimony and child support.10 How do we value these options for equitable distribution purposes? How do we determine their income value? To date, Florida case law does not provide us with definitive answers. In December of 1999, the Second District decided the Seither case, which involved a pro se litigant and had a poor record. In that case the court said “it remains for another case with a better record for this court to further address the treatment of stock options in dissolution proceedings.”11 O ther states have adopted a wide array of different approaches.
If one considers a stock option “deferred compensation,” it would necessarily follow that any such option, if awarded for work performed during the marriage, would constitute a marital asset pursuant to F.S. §61.075, whether vested or not. The Supreme Court of Nebraska recently held that employee stock options and stock retention shares are a form of deferred compensation, vested or unvested, which constitute property which may be subject to distribution in a divorce case if determined to be marital.12 On the other hand, although Colorado has equitable distribution similar to Florida’s, the Colorado Court of Appeals has held that only a vested stock option is “property” subject to classification in a dissolution of marriage proceeding.13
A number of cases have emerged from around the country with interesting, and inconsistent, results. In the Maryland case of Barbara Green v. Michael I. Green, 64 Md. App. 122, 494A.2d 721,
The husband’s stock options were marital property subject to distribution in divorce, although they were personal to him and could not be assigned or sold, where they were acquired during the marriage. . . . Court valuing stock options for purposes of valuation and equitable adjustment in divorce must take an elastic approach and may not adopt an approach which would operate to compel option holder to exercise his option, since to do so would deprive him of the essence of his property interest, which is right to choose whether to purchase. (emphasis added)
In a 1995 Ohio case, Rice et al. v. City of Montgomery, 663 N.E.2d 389 (Ohio App. 1 Dist. 1995), the court held “The taxpayer’s receipt of nontransferable stock options from taxpayer’s employer was taxable compensation,” even though the court recognized “A non-transferable stock option that has an option price equal to the fair market value of the stock does not provide an immediate realization of income.”
A 1996 Ohio case, Yost v. Unanue, 109 Ohio App.3d 294 (1996), states,
Money received by father following exercise of his stock option qualified as nonrecurring income for purposes of determining whether to modify his child support obligation; father had apparently only exercised his stock option on two occasions and the fact that he accumulated options over period of time in excess of three years (a statutory requirement) did not require option to be treated as income, particularly as he earned no income on options until market value of stock exceeded option price, such that he received no value for accumulated shares of stock until he exercised his stock option.” (parentheticals added)
Even though the father exercised the options irregularly, the court considered them as income for child support calculation purposes.
There is law in Florida to support the argument that options for future services are not subject to equitable distribution. In a majority of circumstances, these options are unvested. For instance, if the option contract states that the options are or will be awarded for future services, and any or all of such services will occur after the marriage is over, the practitioner can look to cases regarding the equitable distribution of pensions for guidance. Florida’s Supreme Court has held that post-dissolution contributions to a retirement plan are not subject to equitable distribution,14 and the First District Court of Appeal has stated that benefits not accrued during a marriage are not subject to equitable distribution.15 It is interesting to note that tax courts have found that an item “accrues” when all events occur which fix the amount and determine liability.16 If an option for future performance is for events that have yet to “accrue,” how can the option be subject to equitable distribution?
In a 1999 Ohio case, Graeme Murray v. Susan Murray, 1999 WL 55673 (Ohio App. 12 Dist), the court held
The true value of stock options lies in their future exercise. . . if stock options were valueless at the time of their grant, amounting to no more than a chance to buy stock at its present trading price (a right shared in common with everyone with access to the stock market), it is difficult to believe the stock options would be important considerations in executive compensation. . . the true value of the stock option to its owner is the potential for appreciation in a stock price without investment risk. If the stock price were to drop, the owner simply would not exercise the option since he could instead buy the stock more cheaply on the market.
This court continues by recognizing the Ohio definition of “income” as an all-encompassing definition and that both the company and the husband admitted that the stock options package was a primary component of annual compensation. In this case, an executive for the husband’s company testified about the nature of the stock options as follows:
The options are given every year and may only be exercised by the husband. The options may be exercised for one year after their grant up to 10 years after their grant. In that time, exercise of the options is left solely to husband’s discretion. The price that husband will pay for one year’s option is set as the price on the date the husband is granted the option. When the option is exercised, the husband is responsible for any transaction costs and taxes. The growth of each option is the single most important element of the husband’s complete compensation package, and the options are recurring, sustainable compensation. The husband can expect to receive the executive stock options as long as he continues to work in his position. In fact, the options mirror deferred compensation.”17
The court continued, “We find it significant that after the initial 12 months, the husband has complete discretion to exercise the options, so long as he remains an employee of the company. In this respect, the option then becomes an investment choice, and its value may be imputed as part of the husband’s gross income.”18
Interestingly, though the final decree was filed on May 16, 1994, in this matter, this Ohio Court proceeded to measure the change in value by appreciation of the stock options (which were public and therefore easily measurable) for each of the years from 1994 through 1998. Based on this appreciation, the court ordered a significant (six figures) additional child support obligation to be paid. This court rejected the measurement of the stock options using financial models, such as Black-Scholes, by stating, “We must note that financial models exist for calculating a value for stock options. Although these models are regularly used in the marketplace, they are designed to reflect market forces under certain conditions, and may not be reliable for purposes of litigation.”19 This Ohio court was in concert with a Connecticut court20 On this matter. The Ohio court continued, «We find that the best way to value such stock options is to account for the options’ appreciation in value as determined on the grant and exercise dates of the options which fall into the income year at issue.»21 Of course, the difficulty with this common sense approach is the need for hindsight wisdom.
California, the home of many high-tech companies and a plethora of stock options, recognizes many appellate opinions discussing the methods of characterizing and dividing employee stock options upon dissolution, though none has addressed the issue of how to divide them, other than in kind. The valuation of stock options for purposes of the divorce court’s property distribution naturally would require that a value for the option be determined. In the California case In Re Marriage of Harrison, 179 Cal. App.3d 1216, 1225, 225 Cal. Rptr. 234 (1987), the court held this a proper method of division “which could have been used had the parties presented evidence as to the value of the options.”22
A number of jurisdictions have adopted the “time rule” as a foundation for dividing stock options when the rights under the option agreement were acquired during the marriage. These include California, Missouri, Maryland, New Mexico, and Washington.23
Are options an asset or income? Yes! Just like any contract, the terms of options will vary infinitely. While many of them will behave as an asset because they are nonbiased, going to all employees, and not tied to performance, many others will behave as income-providing incentive for the select few executives with the appreciation tied to some performance measure. The difficulty arises when there is manipulation, intentionally or unintentionally. the nature of the position of an executive, the individual has power to affect prices and perhaps affect terms of the option. It is these issues which must be brought out in testimony and which must be analyzed by the court.
1 Seither v. Seither, 24 Fla. Law Weekly D2814 (Fla. 2d D.C.A. 1999).
2 S hannon P. Pratt, DBA, CFA, FASA, Valuing a Business: The Analysis and Appraisal of Closely Held Companies,
Business One Irwin
3 Website http://www.economist.com/editorial/freeforall/7-8-99/sal604.html, “Share and share unalike,” 7th August 1999, at p. 2.
4 Website http://www.bog.frb.fed.us/pubs/feds/1998/199804/199804pap.pdf, “Corporate Payout Policy and Managerial Stock Incentives,” George W. Fenn & Nellie Liang, March 1999.
5 www.economist.com at p. 4.
6 Id. at 5.
7 Id. at 4-5.
8 F la. Stat. §61.075 (1999).
9 Griffing v. Griffing, 722 So.2d 979 (Fla. 5th D.C.A. 1999); Langevin v. Langevin, 698 So.2d 601 (Fla. 4th D.C.A. 1997); Brown v. Brown, 591 So.2d 1043 (Fla. 1st D.C.A. 1991).
10 Seither v. Seither, 24 FLW D2814 (Fla. 2d D.C.A. 1999).
12 Davidson v. Davidson, 578 N.W. 2d 848 (Neb. 1998).
13 In re Marriage of Balanson, ____ P.2d ____, 1999 WL 515774 (Colo. App. 1999); citing In re Marriage of Huston, 967 P.2d 181 (Colo. App. 1998).
14 Boyett v. Boyett, 703 So.2d 451 (Fla. 1997).
15 Blevins v. Blevins, 649 So.2d 315 (Fla. 1st D.C.A. 1995).
16 Hudson Motor Car v. U.S., 3 F.Supp 834 (Ct.Cl. 1933).
20 Laura R. Chammah v. Walid A. Chammah, 1997 WL 414404 (Conn.Super)
21 Murray case
23 In re Hug, 154 Cal.App.3d 780, 201 Cal.Rptr. 676 (1984); Smith v. Smith, 682 S.W.2d 834 (Mo.App. 1984); Green v. Green, 494 A.2d 721 (Md.App. 1985); Garcia v. Mayer, 122 N.M. 57, 920 P.2d 522 (1996); Stachofsky v. Stachofsky, 90 Wash.App. 135, 951 P.2d 346 (1998).
on Value of European Call and Put Options *
|Value of underlying security (S)||
|Dividends paid on underlying security (D)||
|Volatility of underlying security ( o )||
|Strike price (X)||
|Time to maturity of option (t)||
|Risk-free rate (r f )||
increases, a minus sign means that the value of the option decreases as that factor increases.
Jorge M. Cestero is a partner in the West Palm Beach law firm of Sasser, Cestero & Sasser, P.A., where he concentrates his practice in family law. He received his J.D. from Florida State University and B.A. from the University of Florida. Mr. Cestero is board certified in marital and family law. He is chair of the Family Law Section’s CLE committee and serves as president of the Hispanic Bar Association of Palm Beach County.
Michael J. Mard, CPA/ABV, ASA, is a business appraiser accredited by the American Society of Appraisers and the American Institute of CPAs. He has valued businesses and intangible assets for 16 years, is managing director of The Financial Valuation Group, and founding president of The Financial Consulting Group, a national group of independent financial advisory service firms.
This column is submitted on behalf of the Family Law Section, Ky M. Koch, chair, and Mark A. Sessums, editor.