Equity compensation in the form of stock options has become increasingly more popular in the workplace.  High-tech companies historically have paid employees, consultants, and directors less in salary than other industries, but offered participation in the companies' growth by issuing stock options.  Many employees of these companies have come to expect stock options as part of any routine employment package.  Other industries also are making increased use of stock options.  Many larger, publicly-traded companies now grant stock options in one form or another, and closely-held companies are seeing the benefits of this compensation strategy as well.

Equitable Distribution

The law related to distribution of property in a divorce varies from state to state.  In North Carolina, the triggering event for the distribution of property is not the divorce itself, but the physical separation of the spouses with the intention of at least one spouse to permanently separate and end the marriage.  When spouses separate with the necessary intent, North Carolina law requires that the net value of their property, measured as of the date of separation, be divided in accordance with the principles of equitable distribution.  The basic tenet of equitable distribution is that marriage is a financial partnership and, therefore, the "marriage" is entitled to the fruits of its labor.  Equitable distribution requires the equitable division of the net value of all of the property acquired during the marriage and prior to separation ("Marital Property"), except property acquired by gift or inheritance which is Separate, and not Marital, Property.  (The concept of Separate Property is explained below.)  It follows that any stock option rights earned during the marriage as a result of the work or employment of either spouse are Marital Property and subject to equitable distribution. 

Equitable distribution also includes the division of property acquired after the date of separation and prior to the date of distribution as a result of marital labor or as a result of passive gains or losses in the value of Marital Property.  Such property is called "Divisible Property."  For example, the passive gain in the value of a 401(k) account between the date of separation and the date of distribution due to interest, dividends, or a fluctuation in the stock markets is Divisible Property and is subject to equitable distribution.

The process of equitable distribution encompasses three steps.  First, all property must be classified as Marital Property, Divisible Property, or Separate Property.  Separate Property is property belonging solely to one of the spouses, such as gifts and inherited property as mentioned above, or is property owned by a spouse individually prior to marriage, and is not included in the calculation of net value of Marital and Divisible Property.  Once classified, the Marital Property and Divisible Property belonging to the spouses, or either of them, must be valued.  Upon classifying and valuing the relevant property, Marital Property and Divisible Property then are divided between the spouses.  A 50/50, or equal, division of the total net value of Marital and Divisible Property is presumed to be equitable unless the consideration of certain factors requires an unequal division.

Are Stock Options Subject to Equitable Distribution?

Until 1997, the classification of stock options as Marital Property or Separate Property focused on whether a stock option was "vested" prior to the date of separation.  A stock option is considered to be "vested" when the employee's rights to the stock option are complete, not contingent or conditional, and may be exercised.  However, in 1997, the North Carolina General Assembly amended the definition of "Marital Property" to include both vested and non-vested deferred compensation rights, including stock options.

If a stock option has been earned by a spouse during the marriage and before separation, that stock option is Marital Property regardless of whether the option has "vested," or whether it can be exercised only after the date of the spouses' divorce.  If the stock option has been earned during the marriage and before separation, the stock option is Marital Property and subject to equitable distribution. 

In order for a stock option to be classified as Separate Property, the acquiring spouse must prove that the stock option was acquired, in whole or in part, from services performed by the acquiring spouse either prior to the marriage or after the date of separation.  For example, although a stock option may be received during the marriage and presently owned as of the date of separation, the stock option still could be classified as part of the Separate Property of the acquiring spouse if the stock option was granted solely for services rendered by that spouse prior to the date of marriage. 

Another classification issue arises when a stock option is granted to one spouse during the marriage and prior to separation, but is not received by that spouse until after the date of separation. Such an option is classified as Divisible Property.  While this distinction is important for many other reasons, the treatment of Divisible Property in the context of equitable distribution is no different than the treatment of Marital Property – the net value of the Divisible Property is also equitably divided between the divorcing spouses. 

Valuing and Distributing Stock Options in Equitable Distribution

Issues of price and the exercisability of a stock option, although irrelevant to an option's classification as Separate, Marital, or Divisible Property, are relevant to both the valuation and distribution of the stock option in an equitable distribution proceeding.  Marital Property is valued as of the date of separation, while Divisible Property is valued as of the date of distribution.  Since North Carolina has not adopted any specific approach for valuing stock options, any method that reasonably approximates the stock option's value should be recognized.  For example, the stock option may be valued simply by determining the difference between the option price and the market price of the stock to be purchased on the date of separation or distribution, as applicable, which is known as the "intrinsic value method." 

Another possible method for valuing a stock option is use of the Black-Scholes Stock Option Pricing Model.  This method measures both the intrinsic value and the time value of the stock option and considers several key variables including the exercise price of the stock, current price, volatility, term to expiration, dividend rate, and risk-free interest rate.  This may be the preferred method when the relevant stock is not publicly traded or otherwise does not have a readily ascertainable market price.

While recent North Carolina case law suggests that the valuation of a stock option is essential if the matter comes before a court, spouses can agree to an out-of-court settlement.  Settlements often occur in family law cases, and settlement agreements can ignore the complex valuation issues surrounding stock options and assume that an equal distribution of the net value of the option is equitable.  However, the non-transferable nature of many stock options and the inherent volatility, up and down, in the value of stock options can present challenging transfer and tax issues that must be addressed with legal counsel and in the settlement documents.

Practical Considerations and Conclusion

Substantial information and documentation may be needed to classify stock options as Marital, Separate, or Divisible Property, and to assess the valuation and distribution issues involved in their equitable distribution.  It is necessary to review and understand the terms of the stock option plan, and know the grant date, the number of options, and the expiration date of each option granted.  If an option has already been exercised at the time of the relevant date, the exercise price, the date, and the number of shares purchased also must be known. 
 
There can be many variables involved in the classification, valuation, and distribution of stock options in an equitable distribution situation.  The services of a family law attorney, and perhaps other professionals such as accountants, appraisers, and tax consultants, should be sought in order to ensure that rights in and to specific stock options are maintained and preserved for the benefit of the spouse entitled to an equitable distribution. 

For further information regarding the issues described above, please contact Leslie G. Fritscher.

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This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.