General Practice, Solo & Small Firm DivisionMagazine
VOLUME 19, NUMBER 2 MARCH 2002
DOMESTIC RELATIONS LAW
Exploring the Use of the Time Rule in the Distribution of Stock Options on Divorce
By David S. Rosettenstein
This article describes the roots of the time rule in the law regulating distribution of pensions in divorce. The basic model as applied to stock options is described. The article examines the relationship between the various elements of time and the value of the options themselves and describes how this relationship may be used to achieve a de facto variation of the outcome suggested by the time rule. Adjustments to the time rule formula to take account of pre-grant contributions of both the employee and the marriage toward earning the options are considered. The article then deals with some of the issues arising from complex grant structures with a variety of post-grant concerns, and with demands of equity restructuring.
The roots of the time rule. The time rule applied in the distribution of options owes its origins to the techniques employed in divorce proceedings to distribute pensions. The majority of states have sought to distribute pensions by employing a rule that assumes that pensions are deferred compensation earned throughout the employee's career. Two basic classes of pension are identifiable: defined contribution plans and defined benefit plans. Under the former, the employer and perhaps the employee make specific contributions to the plan over time, and a separate account is maintained for the employee. In principle, the marital share becomes the difference between the account balances at the onset of the marriage and the balance at the termination of the marriage. Where payment is deferred, the marital share is determined by the ratio of the account balance accrued during the marriage to the final balance on retirement.
Under a defined benefit pension plan, a benefit is payable in terms of an established formula, which is usually a function of duration of employment and salary when employment ends. No discrete employee account is maintained, and the pension generally is funded exclusively by employer contributions. What the employee and the marriage "contributed" is time, to which the law must assign a value.
The technique most popularly employed in identifying the appropriate distributable share of whatever value becomes available through the pension plan is provided by the time rule. The portion of the pension that will be attributable to the marriage is represented by a fraction. The numerator is the number of months the couple were married during which the employee was employed by the employer, and the denominator is the total number of months it took the employee to earn the final benefit the pension pays. This fraction is sometimes described as the "coverture fraction."
Stock options-the basic time model. Under the time rule approach adopted in the majority of divorce cases, if the stock option is granted and exercised during the marriage, the resulting shares or the proceeds from the sale thereof will be considered to be marital property distributable in the divorce proceedings. Problems start to emerge where the options are granted during the marriage but do not vest or mature until after the marriage comes to an end. Similar problems arise where the option grant was made prior to the marriage and the option vests during the marriage or after the marriage comes to an end. The issue then becomes what portion of the option is distributable in a divorce proceeding.
Most jurisdictions have imported the time rule and apply this approach to the distribution of options. A general model is that the marriage's distributable share of the overall option grant is determined by the ratio of the number of months the employee was both married to the claimant and working for the employer after the date the option was granted, relative to the number of months that must elapse between the time of the grant and the time the option vests. This basic ratio is the coverture fraction.
Modifying the time elements in the fraction. In principle, where the option aims to recognize the employee's prospective efforts, the numerator in the coverture fraction is the period of time after the option was granted during which the parties were both married and the employee spouse worked for the grantor. Every jurisdiction has to confront the problem of when, for the purposes of property division, the marriage can be said to have come to an end. Generally, each has an established rule for this purpose, which may range from when the relationship broke down or the parties physically separated, to the date on which divorce proceedings were instituted, or the date when the divorce became final.
The time rule attempts to define the efforts a spouse made to earn the option during the marriage. This determination is complicated because the options may be granted to recognize activities prior to the grant rather than subsequent to it. In such an eventuality, relying on a numerator that includes only the time from the date of the grant until the marriage ends may under- or overvalue the distributable marital share.
In principle, two possibilities exist. The pre-grant activities being recognized may have occurred during the marriage or prior to it. If the activities took place totally prior to the marriage, the marriage should not have a claim to the options, according to a time rule. Conversely, where the options are granted in recognition of efforts made before the grant but expended during the marriage, the time rule formula must recognize that fact.
The traditional application of the time rule posits that the option is fully earned at the moment the option vests or matures. Technically, this might not be accurate; the option holder's efforts beyond the vesting date and before the options are actually exercised, for example, continue to contribute to the enhancement of the value distributable under the option grant. Nevertheless, the traditional rule has a certain equitable ruthlessness about it. After all, if the period beyond vesting counted, the employee option holder could extend the period embodied in the time rule's denominator and effectively dilute the marital interest. This issue has been encountered in the pension arena and is dealt with by linking the distributable share to the period that ends when the employee ordinarily would be expected to retire.
The potential for effective deferral of a vesting date also occurs with options. Employers seeking to compensate employees through grants of options have a particular problem when the exercise price of the option becomes higher than the market price of the underlying stock. Although the option may still have value because of the possibility that the share price may recover before the option expires, this may be of little solace to an employee who is looking to the difference between the exercise price of the option and the market price of the stock to give employees their "daily bread." Appreciating this, employers have two basic strategies available to them. The first is to cancel the existing grant and replace it with an entirely new grant, and the second is to reprice the existing grant. Because accounting rules almost inevitably demand an extension in the time before a reprice grant can be exercised, and because such a time extension will also occur when the grant is replaced, jurisdictions need to modify the time rule to accommodate these extensions.
Conventional option schemes require that when the options come to be exercised, the employee pays for the stock at the option's exercise price. Frequently, employees will actually pay for the stock being acquired by surrendering some of the stock to which they are entitled. Accordingly, some option schemes contain so-called reload provisions, under which the employer agrees to issue the employee new options for the equivalent amount of stock that was surrendered to purchase the stock under the original grant. If the right to reload is embedded in the underlying grant, presumably the marriage's share of that right cannot exceed the marriage's share of the underlying grant, as determined by the time rule.
David S. Rosettenstein is a professor of law at Quinnipiac University School of Law, Hamden, Connecticut.
This article is an abridged and edited version of one that originally appeared on page 263 of Family Law Quarterly, Summer 2001 (35:2).