VALUING UNVESTED STOCK OPTIONS AS A MARITAL ASSET IN AN
EQUITABLE DISTRIBUTION DISSOLUTION: INSIGHTS FROM WENDT V. WENDT

Lynn Karlet
 
 

Law & Valuation
Professor Palmiter
Spring, 1999



Abstract
Text of Paper


Abstract
In Wendt v. Wendt, the court determined how unvested stock options were to be valued during a divorce in an equitable distribution jurisdiction. Historically and in jurisdictions other than Connecticut, unvested stock options or other expectancies were not treated as marital property because a mere contractual right cannot be valued because at present nothing exists to be valued.

ISSUES

1.  Are unvested assets to be considered marital property?

2.  If so, then how are unvested assets to be valued during a divorce in an equitable distribution state?
RULES

1.  The stock options need to be classified by examining several factors, such as the nature of the employment agreement regarding the options.  If the unvested options were awarded for past and present services, then they should be considered marital property, but if they are for future services, then they should be considered separate property.

2.  The Wendt court used legal and equitable concepts from both community property and equitable jurisdiction jurisdictions in order to arrive at a formula, the time value coverture formula, for valuing unvested stock options.  However, actual shares instead of cash value were awarded based on the speculative nature of the formula and the volatility of the stock prices for the stock involved in this case.
ANALYSIS

First, the court decided that there was no market for unvested stock options.  These options were subject to certain contingencies, and only a reasonable determination of whether these contingencies might or might not occur was necessary, not a certainty.  The nature of the asset must be determined in order to determine its value.  Essentially, an unvested option could be viewed as an expectancy, which has no value until realized, or it could be viewed as a chose in action, as has been done in community property states such as California.  The employment agreement regarding the stock options should be examined in order to determine whether they are a reward for past, present, or future work or accomplishments.  The Wendt court chose to use the gravamen test from an Indiana decision, Hann v. Hann, in order to determine how to classify unvested stock options. This test ignores the vesting requirement and examines whether any of the rights to stock options were present. If so, then the coverture factor of equitable distribution law would be applied to those rights.  The court believed that no single formula applies to every case, but chose to use the time rule coverture formula in this case in order to calculate the ownership ratios to determine what percentage of the unvested options should be designated marital property.  The coverture factor is the date the stock options were granted minus the date of marital separation all divided by the date the stock options were granted minus the date the stock options vest. The options that were determined to be based on past and present services were considered marital property while those to be based on future services were to be considered separate property.  After classification, then valuation of those options to be considered marital property must be completed.  The court chose to employ the intrinsic value method in order to value the unvested stock options that were determined to be marital property.  This involves subtracting the strike price from the market price at some point in time and then multiplying the result times the number of shares granted by the option, while assuming the options were immediately exercisable.  However, other factors may also need to be taken into consideration, such as brokerage fees, margin interest, and tax consequences associated with exercising an option.  The Wendt court chose to award to the wife a quantity of shares, rather than a monetary amount, based on the appreciation of the value of the shares that occurred during the trial, as the point in time to be used in the intrinsic value method is too speculative when price share fluctuates as significantly as did the unvested shares involved in this case.



 
Text

Introduction

Marital dissolution cases fill the dockets of nearly every non-federal courthouse in the United States. Apart from sheer numbers, mostly these cases are unremarkable tragedies that come to a legal conclusion. Occasionally, a high profile celebrity case captivates public attention through the media. The recent Connecticut decision Wendt v. Wendt,  l998 WL 161165  (Conn. Super.) provided business types with grist for boardroom chat among highly compensated elite in corporate America. For background information, see the lay person's overview of the case from the pages of Fortune magazine.
 


Why Wendt is important

As a Connecticut state case, Wendt's immediate effects are local. But for its notoriety, Wendt is an unremarkable case. In fact, shepardizing Wendt shows it has not been cited by any other case.  But the reasoning used in valuing Gary Wendt's unvested general Electric common stock options earned as Chief Executive Officer of GE Capital Services (GECS), General Electric's most profitable division, will prove highly influential. While not creating any precedent-setting legal theory, the case is notable for dealing with the use of a "coverture formula" for the first time at the appellate level in Connecticut. Aside from being a victory for non-working spouses of high net worth (greater than $5 million) long term (greater than fifteen years) marriages, the case alters the calculus for rewarding corporate executives according to Wendt's legal and equitable conclusions, plus those of similar cases. How and when to pay high ranking employees, particularly when they may bring legal action against a spouse, can now be an important condition of employment. To reach its holding, the court synthesized its method for valuing unvested stock options by borrowing persuasive authority from both community property and equitable distribution jurisdictions.
 


Ground Rules

The plaintiffs attorney, Robert Epstein, criticized Mrs. Wendt's counsel for "attempting to convert Connecticut from an equitable distribution state to a community property state, [so] the wife would be entitled to 50 percent." (Lori Tripoli,  Divorce Litigation Update ...  High Profile Cases Promise New Law.  Inside Litigation  (12 NO 8 Inside Litig. 1 August 1998)) "Fifty percent of what?" is a logical question that would have differing answers in Connecticut depending on 1) how the asset was classified, 2) what valuation was placed on it, and 3) how it was distributed between the parties as expressed in Krafick v. Krafick, 663 A.2d 365 (Conn. 1995). Long before Mr. Epstein's remark, equitable distribution states had been borrowing law from community property states in dividing many differing types of assets, both vested and unvested: pensions, stock options, stock appreciation rights (SARs), restricted stock, stock ownership purchase plans (ESOPs), incentive bonuses, etc ....even frequent flier miles! (Sally Burnett Sharp.  Step by Step: The Development of the Distributive Consequences of Divorce In North Carolina (76 N.C. L. Rev. 2017 September 1998 ) What status the law accords unvested rights needs to be established before any legal impact on valuation can occur.

Theories: Are unvested rights capable of rational valuation

Marketability

The evidence in Wendt established that there is no current market for GE unvested stock options, nor that anyone ever sold or traded GE unvested stock options. The court concluded, therefore, that no market for the asset exists until the rights are vested. (Wendt at 199).

Mr. Wendt's stock options were subject to four general contingencies: (1) events not likely to occur (e.g. GE being purchased in a hostile takeover); (2) those largely within his control (e.g. he remain effective in his position as CEO of GECS); (3) GE's right to amend, alter, suspend, discontinue or terminate the plan individually or company wide; or 4) the options would also vest at Mr. Wendt's death, and then be exercised by his estate.

These contingencies, along with the passage of time, are dispositive on the issue of vesting. Under the authority established in Raccio v. Raccio, 556 A.2d 639 (Conn. 1987), mathematical accuracy is not a prerequisite to determining how the "estate" of a spouse may be divided. Under Falco v. James Peter Assocs., 335 A 2d 301 (Conn. 1973), the plaintiff need supply sufficient evidence for the trier of fact to make a reasonable determination if  not mathematically certain as to quantity of damages. Mrs. Wendt, therefore, perhaps only need show that it is reasonably certain that her spouse will continue in his present capacity at GECS if he lives or the probability that GE would discontinue the stock option plan, which testimony reflected was only 3% of all cases.

Expectancy versus contract right

By 1940, unexercised vested options incepted during the pendency of marriage, in a divorce context, were viewed as stock value less costs of acquiring the shares and tax considerations. Estate of McKetterick, 42 B T A 130 (1940). "[A] stock option is the contractual right to buy or sell stock in the future at a predetermined price... ". Regier v. Rhone-Poulenc Rorer. Inc., 1995 U.S. Dist. LEXIS 9384 (E.D. Pa. July 3, 1995). Exercising vested stock options, SARs, or the vesting of an ESOP during marriage will generally result in the acquisition of shares for marital property purposes. Darwish v. Darwish. 300 NW.2d 399, 402-03 (Mich. 1980).

The question of how to value an unvested stock option never arose in a marital dissolution case until 1976. In re Marriage of Hug, 154 Cal. App. 3d 780 (Cal. 1984). Until the 1980s, many courts did not recognize unvested rights acquired during marriage as property nor accurately value such rights when they were found to exist. To some courts, an unvested right is-still a mere expectancy not in esse, even as recently as 1996 in the Colorado case In re Marriage of Miller, 915 P.2d 1314 (Colo. 1996). Such holdings rely on the law of future interests and imply that until and unless contractual duties of the employee spouse are performed, usually in the course of employment, nothing exists that can be valued.

Probable Result in North Carolina

The same logic applied to a curious 1994 North Carolina decision Godley v. Godley, 429 S.E.2d 382, 394 (N.C, 1993). A two million dollar real estate commission., substantially earned on a transaction not yet consummated as of the date of separation, was deemed not marital property because the husband "had a mere contractual right to receive an uncertain amount of commissions at some time in the future [, if at all,] and the right to receive the commissions therefore had not vested on the date of separation." (id. at 392). Earlier, in 1984, the North Carolina Appeals Court held in Hall v. Hall, 363 SE.2d 189, 195 (N.C. 1987) that any stock options "vested" (exercisable) as of the separation date are marital property, but any contingent interest not exercisable by then required separate property treatment. Even though North Carolina, like Connecticut, is an equitable distribution jurisdiction, decisions on similar facts seem to vary widely from one equitable distribution jurisdiction to another. With such consistent holdings in North Carolina, however, Mr. Wendt would have clearly had a different result in our jurisdiction on the issue of whether his unvested compensation was in esse and, therefore, capable of valuation.

Connecticut Precedents

The issues for the Connecticut court are 1) whether unvested "rights" are marital property or a mere expectancy (as noted in the two NC cases and the Colorado case cited supra) and 2) if such rights  are  marital property, what method shall be employed to value such assets. On the one hand, in Connecticut a "mere expectancy" is not property. Eslami v. Eslami. 591 A.2d 411 (Conn. 1991). On the other hand, "'the fact that a contract right is contingent upon a future occurrence does not degrade that right to an expectancy." Krafick v. Krafick, 663 A.2d 365 (Conn. 1995). Proper categorization of the asset, therefore, is the critical prerequisite in determining what value, if any, will be assigned and determining the asset's divisibility in Connecticut.

Another Theory: Unvested stock options as a chose in action

While some courts recognize the law of future interests by categorizing an unvested right acquired in employment as an expectancy, others reason that stock options, vested or not, resemble the common law chose in action. Di Tolvo v. Di Tolvo. 328 A.2d 625. 629 (N.J. 1974). A contract gives rise to rights and duties and is expressly not an expectancy; it is, rather, a species of property capable of valuation vis-a-vis performance of the requisite contractual duties by the employee spouse. In California, a community property state, this concept was first recognized In re Marriage of Brown. 544 P.2d 561, 566 (Cal. 1976,), a 1976 case. Once the contract right is established as property, the court must then assign a value to it.

One More Factor: Stock options in light of the employment agreement

One possible interpretation of the nature of unvested stock options, restricted stock, and the like is that they are a type of "wage substitute." (Thayer v. Thayer, 409 A.2d 1326, (N.H. 1979). Stock options are a convenient and cheap way for corporations attract, recruit, remunerate, and retain valued employees, particularly among those of high ranking. The SAP, a close cousin of the stock option, can even be structured so that the cash payment avoids brokerage expenses and may even be designed to "overcompensate" to allow the employee to satisfy the short term capital gain tax consequence of the SAR transaction. Restricted stock is another variant of this type of deferred compensation.

With such diverse characteristics among pay out schemes, apparently stock option provisions in employment contracts vary considerably. The intent of the parties, therefore, may be useful in classifying the asset under first criterion of Krafick. If stock options are granted for past performance, the employment agreement might refer to promotion, completion of an important project, or similar language referring to past accomplishments. If stock options are granted for present performance, the employment agreement might refer to management's desire to retain key executives or the date of vesting contemporaneous with some specified event in the present. If stock options are granted for future performance, the employment agreement might refer to long term retention of executives, the requirement of continued employment, and other "golden handcuff' references.

Mr. Wendt's option plan could be categorized solely as a pair of "golden handcuffs" which imply reward for future employment. The option agreement language refers to an "incentive to remain with GE indefinitely in the future." The agreement also refers to Mr. Wendt as "a long and valued employee who has performed at an extremely high level implying compensation for past and present employment subject to distribution according to a "coverture factor' discussed infra. (Wendt at 166).

Connecticut's approaches to valuation of the spousal share under Krafick

Classing Unvested Stock Options: Gravamen Test

The Wendt court decided that the gravamen test from the dissent of an Indiana opinion Hann v. Hann, 655 N.E.2d 566, 574 (Ind. 1.995 best reflected Connecticut law. (Wendt at 158). Using the Hann test, the Wendt court ignored the vesting requirement altogether and instead tested whether any rights to stock options were present and if so, the court: would apply the "coverture factor" under the state's equitable distribution law to them.

Valuing Unvested Stock Options: Intrinsic Value

Valuation is a critical aspect of any divorce case. Thomas W. Crockett and J. Randall Patterson, Dividing Property in Marital Dissolution (62 Miss. L.J. 57 Spring, 1992. Unlike wages, stock options vary in value. Stock options are not generally cash payments, unless awarded through an SAR, but rather confer a right to the employee spouse; in this respect they differ substantially from wages.  Many courts have relied on the widely accepted Black-Scholes Model for pricing options when valuing these assets. Les Barenbaum and Walt Shuber, Measuring the Value of Executive Stock Options, Fair$hare (12 NO. 12 Fair$hare 3 December, 1992).  For an overview on this Black-Scholes model for pricing stock options, see Bradley University's Foster College of Business Administration site.

The Wendt court used its discretion and sense of equity in abandoning convention and employing the intrinsic value method to value the unvested stock options that were a part of the marital estate See Appendix infra..). The court simply subtracted strike price from market price at a point in time and multiplied the result times the number of shares granted by the option, while assuming the options were immediately exercisable.

The strike price is not the end all in valuing a stock option because sale price, rather than net proceeds, tends artificially inflate expectations to a level not realizable by the liquidating spouse. Melvyn B. Frumkes and Stephen W. Sessums, Equitable Distribution in Dissolution of Marriage: Consideration of Contingent Tax Liabilities of Assets in Valuation and Distribution (61-APR Fla, B.J. 45 April, 1987). If the strike price happens to be above market rice the option may be worthless at a given point in time. Brokerage fees, margin interest, and tax consequences are all costs associated with exercising an op ion a; mus a proven o e fact m ear m order to adjust valuation. One Wisconsin court required a defendant to prove a tax consequence of selling his stock in order to factor a tax liability into the allocation of divisible property. Without the required proof, a court would be forced to speculate as to the effects of future changes in tax laws. In re Marriage of Nemitz, 376 N.W.2d 243, 248 (Minn. 1985). The defendant was unable to prove adverse tax consequences concretely and was forced to liquidate additional assets to satisfy the judgment, further damaging himself in the process. (Id.)

The court awarded Mrs. Wendt a quantity of shares rather than the dollar figure that the shares represented at the date of separation, so she was able to participate in the handsome appreciation of GE common stock during the course of the trial. This solution simplified the tax impact, eliminating the capital gain tax consequence to the liquidating spouse.

Regardless if a valuation method is widely accepted or simplistic, the point in time used for pricing the shares is controversial, particularly when share price fluctuates, such as in the instant case where the bench took judicial', notice that GE common stock doubled in value during the course of the trial. (Wendt at 208).

Distributing Unvested Stock Options: "Time Rule" Coverture Formula

Stressing that no single formula universally applies to the facts of every case, the court determined that a coverture formula expressing the "time rule" from Hug supra applied to the facts of the instant case. (Wendt at 184) Using that formula, the court attempted to calculate the ownership ratios to determine what percentage of the asset to allocate as marital property with the remainder, if any, as separate property.

Coverture Factor = Date Stock Option Granted - Date of Marital Separation

                       Date Stock Option Granted - Date Stock Option Becomes Exercisable (i.e. Vesting Date)
Since the appeals court ignored the vesting requirement, the stock options representing past or present services of Mr. Wendt were allocated to marital property; those based on future services were allocated to property Mr. Wendt's separate property. Allocation of each type of property was based on when vesting occurs in relation to the hypothetical end of the marriage, the date of separation, resulting in an artificial apportionment that approximates the equitable theory behind the method.

Conclusion

Connecticut had never dealt squarely with the issue of valuing unvested stock options as a part of deferred compensation in the context of a marital dissolution prior to Wendt. Arnold H. Rutkin Editor's Column, Family Advocate (Winter, 1997). In cobbling together its own law, the bench borrowed legal and equitable concepts from both community property and equitable distribution jurisdictions. The simplified valuation method used to price the unvested stock options was largely overcome by awarding Mrs. Wendt shares rather than the cash value of the options at an arbitrary point in time. The case has not helped settle the law in this area, except maybe in Connecticut, but its influence on corporate compensation will probably be greater than any effect on stare decisis.

References

Les Barenbaum and Walt Shuberit, Measuring the Value of Executive Stock Options, Fair$hare (12 NO. 12 Fair$hare 3 December, 1992)

Thomas W. Crockett and J. Randall Patterson, Dividing Property in Marital Dissolution (62 Miss. L.J. 57 Spring, 1992).

Melvyn B. Frumkes and Stephen W. Sessums, Equitable Distribution in Dissolution of Marriage: Consideration of Contingent Tax Liabilities of Assets in Valuation and Distribution

(61-APR Fla. B.J. 45 April 1987)
General Electric Annual Report 1994 GE Capital Services Portion

Betsy Morris,  It's Her Job Too, Fortunes, February 2, 1998

Arnold H. Rutkin, Editor's Column, Family Advocate (Winter, 1959)

Sally Burnett Sharp, Step by Step- The Development of the Distributive Consequences of Divorce in North Carolina, (76 N.C. L. Rev. 2017 September, 1998)

Lori Tripoli, Divorce Litigation Update...High Profile Cases Promise New Law, Inside Litigation, (12 NO. 8 Inside Litig. 1 August 1998)
 


Table of Cases

Darwish v. Darwish, 300 N.W.2d 399 (Mich. 1980)

Di Tolvo v. Di Tolvo, 328 A.2d 625 (N.J. 1974)

Eslami v. Eslami, 591 A.2d 411 (Conn. 1991)

Estate of McKetterick, 42 B.T.A. 130 (1940)

Falco v. James Peter Assocs., 335 A.2d 301 (Conn. 1973)

Godley v. Godley, 429 SE.2d 382 (N.C. 1993)

Hall v. Hall, 363 SE.2d 189 (N.C.1987)

Hann v. Hann, 655 N.E.2d 566 (Ind. 1995)

In re Marriage of Brown. 544 P.2d 561 (Cal. 1976)

In re Marriage of Hug, 154 Cal. App. 3d 780 (Cal. 1984)

In re Marriage of Miller, 915 P. 2d 1314 (Colo. 1996)

In re Marriage of Nemitz 376 N.W.2d 243 (Minn. 1985)

Krafick v. Krafick, 663 A.2d 365 (Conn. 1995)

Raccio v. Raccio, 556 A.2d 639 (Conn. 1987)

Regier v. Rhone-Poulenc Rorer, Inc., 1995 U.S. Dist. LEXIS 9384 (E.D. Pa. July 3, 1995)

Thayer v. Thayer, 409 A.2d 1326 (N.H. 1979)

Wendt v. Wendt, 1998 Conn. Super. LEXIS 1023 (Conn. 1998)

Wendt v. Wendt, 1998 WL 161165 (Conn. Super.)

Materials Consulted But Not Cited

Bodin v. Bodin, 955 S.W.2d 380(Tex 1997)

Black's Law Dictionary (6th Ed., 1990)

Everett v. Everett, 489 N.W.2d 1111 (Mich. 1992)

Robert D. Feder, Valuation and Distribution of Marital Property, Mathew Bender, Vol. 1 - 3, (4th Ed., 1998)

Langevin v. Langevin, 698 So.2d 601 (Fla. 1997.)

Loma Wendt's Institute for Equality in Marriage

New York Post Article on Loma's post trial petition for her share of the GE shares

In re Powell, 934 P.2d 612 (Or. 1997)

In re Short, 859 P.2d 636 (Wash. 1993)

Carolyn J. Woodruff, Other Employee Benefits and Related Issues, Equitable Distribution 1997, Ch. 13, Wake Forest University School of Law Continuing Legal Education (1997)

Appendix

(From Wendt 1997 WL 752374 (Conn. Super.), FN 25)

Summary of "Intrinsic Value" method:

There are eight separate dates of vesting so eight separate coverture factors have to be calculated.

1: 70,000 units granted 9/10/93 vesting 9/10/98 divided by date of farant 9/10/93 to 12/1/95 = 27.7 = 44.5%

70,000 x 44.5% = 31,150 units to be divided.
$72-$48.3125 exercise price = $23.6875 intrinsic value per share x 31,150 units = $737,866
2: 5,000 units granted 6/24/94 vesting 9/24/98 divided by grant date 6/24/94 to 12/1/95 = 17.233 = 44.19%
5,000 x 44.19% = 2210 units to be divided.
$72-$46.25 exercise price = $25.75 x 2210 units = $56,908
3: 57,500 units granted 9/16/94 vesting 9/16/97 divided by grant date 9/16/94 to 12/1/95 = 14.5 = 40.277%
57,500 x 40.28% = 23,161 units to be divided.
$72-$51.00 exercise price = $21.00 x 23,161 = $486,381
4: 57,500 units granted 9/16/94 vesting 9/16/99 divided by grant date 9/16/94 to 12/1/95 = 14.5 = 24.166%
57,500 x 24.17% = 13,898 units to be divided.
$72-$51.00 exercise price = $21.00 x 13,898 units = $291,858
5: 57,500 units granted 9/15/95vesting 9/15/98 divided by grant date 9/15/95 to 12/1/95 = 2.566 = 7.12%
57,500 x 7.12% = 4094 units to be divided.
$72-$63.8750exercise price = $8.125 X 4094 = $33,264
6: 57,500 units granted 9/15/95 vesting 9/15/2000 divided by grant date 9/15/95 to 12/1/95 = 2.566 = 4.28%
57,500 X 4.28% = 2461 units to be divided.
$72-$63.8750 exercise price = $8.125 X 2461 = $19,996
7: 57,500 units granted 9/13/96 vesting 9/13/99 divided by grant date 9/13/96 to 12/1/95 = 0 = 0%
57,500 X 0% = 0 units to be divided.
$72-$88.375 exercise price = 0
8: 57,500 units granted 9/13/96 vesting 9/13/2001divided by grant date 9/13/96 to 12/1/95 = 0 = 0%
57,500 x 0% = 0 units to be divided.
$72-$88.375 exercise price = 0
Total "intrinsic values" after application of coverture

 
1) $ 737,866

2) $ 56,908

3) $ 486,381

4) $ 291,858

5) $ 33,264

6) $ 19,996

7) 0

8)0

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$1,626,273