MEMORANDUM
BACKGROUND
Counsel represents wife in a bitterly contested marital dissolution proceeding. Wife is a rising production executive at Growth.com, where she began employment in 1990. Wife and her husband were married May 10, 2000 and separated August 20, 2009. There are two children of the marriage, Howard and Kevin, ages six and seven. The case is set for trial November 8 in superior court.
ISSUES
1. As of 33 days before separation, Wife received performance incentives from Growth in the form of restricted stock and options that will not vest for one to five years or more. Both awards are subject to forfeiture if Wife is terminated for cause, leaves Growth voluntarily, or does any act to compete with Growth before the awards mature. What is the community's interest in these assets?
2. The marital residence, bought as community property with a mortgage obtained through a Growth employee benefit program, will probably have to be sold for less (net of closing fees and costs) than the unpaid mortgage balance. Since the lender cannot obtain a deficiency judgment on a residential purchase money mortgage, Husband wants to negotiate a short sale or let the lender foreclose. Wife believes that she and Husband have a moral obligation to make the lender whole, and that a default would harm her credit and her career at Growth, from which Husband will continue to benefit through spousal and child support. Is Wife entitled to a contribution from Husband to pay off this debt?
SUMMARY
1. The restricted stock and options should be apportioned with a time rule ratio, but the ratios Husband proposes are incorrect because they mischaracterize the period in which the assets were earned.
Wife's calculations use the correct ratios. The numerator of all the ratios is the period from grant to separation (33 days). The denominator of each ratio is the period from date of grant to date on which each block of rights matures or vests. But contrary to Wife's analysis, neither the stock nor the options can be evaluated by the share price as of the separation date because the value of the awards is in the anticipated increase in the stock's price during their term. Any evaluation must recognize the upside potential. This will inevitably be speculative, but something on which Wife and Husband could perhaps agree. If they cannot agree, the court may continue the community's interest in the awards until they vest.
2. The negative equity in the marital residence would not normally be chargeable against the community estate because it is not money the parties are legally obligated to pay. There may be an equitable argument for asking Husband to contribute anyway, but the court's authority to do so is questionable.
DISCUSSION
1. The restricted stock and optionsA. Terms and circumstances of the grant
As of 33 days before separating from Husband, Wife received two performance incentive awards from Growth: 397 restricted shares of Growth common stock and options to purchase 2779 shares of stock at $50, its then market price. Both the restricted shares and the options are held under a "Stock Incentive Agreement" between Wife and Growth. From its format and terms, the Agreement appears to be a standardized part of Growth's executive performance incentive package.
The restricted shares, or some of them, vest on the fifth anniversary of the grant date. If Growth's rate of return to shareholders over that period is less than the arithmetic average rate for five similar companies, the number of shares vested is reduced proportionately and the balance remains restricted for five more years, after which a new index is computed and applied to those shares. Before vesting, the shares are entitled to vote and to receive dividends, but they cannot be sold or transferred. Until vesting, the shares are forfeited if employment ends for any reason other than death, disability or retirement, or if the employee accepts any compensated employment with any other brokerage firm.
The options vest incrementally: half on the first anniversary of the grant and half on the second anniversary. As with the restricted stock, termination of employment before vesting forfeits the options. Even after vesting, accepting competing employment forfeits any unexercised options.
B. Applicable law
The leading case on apportioning "intermediate" stock options and restricted stock--employment awards, whether vested or unvested, that are granted to an employee before separation but only exercisable thereafter--is Marriage of Hug (1984) 154 Cal.App.3d 780.Analogizing such awards to retirement benefits, the court approved the use of "time rules" for allocating interests in such assets, but emphasized that no single rule fits all cases. Choosing the appropriate time rule, if any, depends on whether a particular stock option plan can best be characterized as compensation for future services, for past services, or both, viewed in light of all the circumstances of the grant. Id., at 786. "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 792.
In its more familiar pension benefits setting, a time rule determines the community interest in the pension based on the ratio of employment during marriage to total length of employment. Id., at 784, citing In re Marriage of Judd (1977) 68 Cal.App.3d 515; In re Marriage of Adams (1976) 64 Cal.App.3d 181). Under the particular circumstances of the Hug grant, the court determined the community interest in each block of options to be measured by the ratio of the period of employment during marriage to the period from the start of employment to the date when each option became exercisable. Id., at 782.
In Hug, the trial court impliedly found that the options at issue were primarily deferred compensation earned from the beginning of employment. Thus the court counted the whole period of employment, rather than the time from the grant of the options only, and continued the spouses' joint ownership interests in the community options. Affirming, the court of appeals noted that the operative agreement replaced a prior agreement that covered the period from the commencement of employment. Id., at 789. But as to distribution, the court said that when options can be valued, the value of the community interest should ordinarily be determined as of the date of separation. Id., at 793.
Later cases have endorsed Hug's principles and have applied a time rule but have not applied the same ratio as in Hug because, in each case, the appellate court has affirmed the trial court's finding that the options' primary purpose at issue was future incentive rather than deferred compensation. When options are awarded as a future incentive to a married employee, the community interest in these options is smaller than it would be if the options were treated as deferred compensation, because future incentives begin to be earned from the date of the grant, not from the date of employment (or marriage, whichever came later). So holding, the court in the first reported case after Hug took the ratio of months from grant to separation / months from grant to exercisability. Marriage of Nelson (1986) 177 Cal.App.3d 150, 155. The decision said nothing about vesting, but it did endorse the employee spouse's argument that "the price of [the employer's] stock must increase in value after the date of exercisability for the employee to realize a gain so the options reward only future rather than past efforts." Ibid., and see fn. 3.
In Marriage of Harrison (1986) 179 Cal.App.3d 1216, 1227, options to buy restricted stock were recognized as "golden handcuffs" and thus as future compensation, not deferred compensation. Significantly, unlike Hug and Nelson, Harrison involved two different kinds of intermediate options: nonqualified options (where stock was fully vested when acquired) and qualified options (where exercising the options fixed a price at which restricted stock could be acquired, but the stock remained subject to forfeiture for some time before it became fully vested.) The nonqualified options were treated as in Nelson, but the apportionment ratio for the qualified options required a larger denominator: the period from the grant date (when the right to the shares began to be earned) to the vesting date (when the shares were fully earned and no longer subject to forfeiture.) Under this formula, the community property interest in each block of shares bought under the option (subject to reimbursement for purchase of the option and any taxes paid) was equal to (Time from date of grant to date of separation / Time from date of grant to date on which shares would vest fully) x (gain on option on date of exercise). Harrison, 179 Cal.App.3d at 1223-1225.
The latest case on point, Marriage of Walker (1989) 216 Cal.App.3d 644, follows Harrison. Here the employee (E) began a new job in 1983, 26 months before separation after an 18-year marriage. During this employment E was granted several options to buy restricted stock, all at the then-market value. The option exercise dates varied and the restricted stock, as in Harrison, vested on different dates. Less than three months before separation, E's employer was acquired by another company, immediately accelerating E's right to exercise all options and immediately vesting all his restricted stock. The trial court applied Nelson's formula rather than Harrison's. Thus it relied on the dates the options were exercisable rather than the dates the shares became vested. It reasoned that vesting did not matter because, in view of the acceleration, "`the stock received by Respondent/husband [i.e., E] was community property to the same extent as the stock option was community property.'" Id., 216 Cal.App.3d at 650, quoting trial court's statement of decision.
The court of appeal reversed, holding that, by following Nelson and not Harrison, the trial court had abused its discretion and credited the community with more than it had earned.
As shown 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. . . . [W]hen 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.Id., 216 Cal.App.3d at 651.
In other words, the trial court relied on the acceleration of vesting to override the gap between the option date and the vesting date, but the appellate court relied on the time rule concept to override the acceleration of vesting.
Thus the trial court has broad but not unfettered discretion to apportion the value of "intermediate" stock options and restricted stock. Each case is decided on its facts and the option's primary purpose is the threshold issue. To the extent the option is deferred compensation, it must be apportioned according to marital status over the period in which it was earned. Marriage of Hug, supra, 154 Cal.App.3d at 785-789; W. Hogeboom, Cal. Prac. Guide: Family Law ¶ 8:1248, p. 8.-301 (Rev. #1, 1994). A time rule may also apply to "incentive" options, but the starting date is the grant date, not the date when employment (or marriage, if later) began. Marriage of Nelson, Marriage of Harrison, Marriage of Walker. When the asset to be divided is a "qualified" option (an option to buy restricted, forfeitable stock), the denominator for the apportionment ratio is measured not by the date the option can be exercised, but by the date the option shares, if any are acquired, will fully vest. Marriage of Harrison, Marriage of Walker. The time rule apportionment fraction may be applied to whatever net "asset" is to be divided: the number of options, the amount of stock, or the actual gain on either or both. Marriage of Walker, 216 Cal.App.3d at 652.
Unconditional options can sometimes be valued as of the separation date because they may be publicly traded or otherwise subject to appraisal (Hug, 154 Cal.App.3d at 793; Harrison, 179 Cal.App.3d at 1225 fn. 2), but conditional or qualified options cannot be so valued because they are subject to forfeiture for reasons that are at least partly within the employee spouse's control. In such cases the court's decree will normally continue the spouses' joint ownership interest in the community options until they are exercised and any stock acquired is fully vested. Ibidem.
C. Analysis
In Wife's case, the Stock Incentive Agreement's terms show that the awards to Wife are performance incentives, not a bonus for past service or a deferred compensation plan. Nothing in the agreement suggests that its terms would be any different if Wife were new at Growth. Thus, unlike the options in Marriage of Hug, Wife's options were not earned by service before the grant date. Furthermore, the awards are clearly "golden handcuffs" like those in Marriage of Harrison and Marriage of Walker, since they do not vest immediately and are subject to forfeiture under various contingencies.
Thus a time rule is appropriate in this case, but not the rule the court applied in Hug and that Husband advocates here. Rather, just as Wife advocates, the numerator of the apportionment ratio must be smaller and the denominator must be larger, in line with Nelson, Harrison and Walker. The numerator for both awards should be the period from date of grant to date of separation (33 days). The denominator for each award should be the period from the date of grant to the period at which the rights under that award become fully vested.
One half of the 2779 options are exercisable 365 days after the grant. The community interest in these options is 1389.5 x 33/365 = 126 options. The balance matures 730 days after the grant, so the community interest in those options is 1389.5 x 33/730 = 63 options. Thus the total community interest in the options is 189 options.
All or part of the 397 shares of restricted stock (depending on whether Growth outperforms or underperforms its leading competitors) vest 1825 days after the grant. The community interest in these shares is therefore 33/1825 (about 1.81 per cent) of the number of shares that vest on the first maturity date. Unvested shares, if any, are subject to a further 1825-day restriction. The community interest in these shares would be 33/3650 (about 0.90 per cent). If all shares vest on the first maturity date, the community interest will be about 7.18 shares.
As explained in the summary and the discussion of Hug above, it would be error to evaluate the restricted stock or the options as Wife has done as of the date of separation. The value of any option is in the upside potential during the option term. The share price 33 days into a term of 365, 730, or 1825 days has very little bearing on this value.
Even if Wife stays with Growth and Growth prospers, as Wife hopes, Husband's half of the community's small share of the asset value will be relatively small. The stock recently traded at about 81. If that were the average price when the options were exercised, the gain would be about $15 per share, and Husband's share would be 15 x 189 = 2835/2 = $1417.50. Thus, independent of tax considerations (which this analysis ignores), Husband would be entitled to about $100 from the options for each point that Growth shares increase above the option price. Thus the options' maximum plausible value is not very great.
The same reasoning applies to the restricted stock, with a tiny wrinkle for dividends. In the best case, there are about 7.19 community shares vesting on 6/23/2014. If each share were then worth $100, Husband's half of the community interest would be $359.50. Meanwhile, her half of the community interest in the dividend stream (assuming continued declarations at the current rate of $3.20/year) would be 7.19 x 3.20 = $23.00/2 = $11.50 per year for five years.
2. Negative equity in marital residenceA. Additional facts
On October 19, 2004, Wife and Husband bought the marital residence for $328,000 under a Growth employee benefit program. Wife presently occupies the home but wants to sell it, even at a substantial loss. A realtor has suggested listing the property at $278,000 and thinks it will bring $265,000 to $273,000, resulting in negative equity. Husband does not want to sell the home if he will be charged with half the loss. He points out that the unpaid mortgage balance is uncollectible under California's anti-deficiency law, Code of Civil Procedure §580b.
When an employee sells a home bought under the Growth home purchase assistance program and relocates to another Growth position, Growth pays 100% of the seller's closing costs and expenses and 90% of any loss. According to Husband, Wife expects Growth to relocate her to Boston in June and to announce the new assignment by the end of March. He suggests that, if this happens, "Growth will buy the house and we may well lose nothing on the sale." But Wife denies that she expects to relocate anytime soon, and Husband's extensive discovery effort has failed to turn up any evidence that relocation is imminent.
B. Analysis
If it were true that Wife is soon to be reassigned to Boston, triggering Growth's contractual duty to pay all escrow costs and 90% of any loss after escrow, Wife's position would indeed be untenable. To repay the lender would then be a waste of community assets, since Growth's payment would make the lender whole without any contribution from the community estate. Neither Wife's credit nor her career would be at risk, and the anti-deficiency rule would have no bearing on the case. The rest of this discussion assumes that Husband will not be able to prove that Wife is being relocated. Wife's position is still very hard to sustain.
As a general rule, a court determining the disposition of marital property must divide the "community estate"--the community and quasi-community assets and liabilities--so that the spouses receive equal net values (assets less liabilities). Fam. Code §2550; CRC 1242; Marriage of Olson (1980) 27 Cal.3d 414, 421; Marriage of Garrity/Bishton (1986) 181 Cal.App.3d 675. Under this rule, absent the anti-deficiency statute, each party would simply bear half the total loss on the sale of the marital residence. But if there is no deficiency judgment, the community suffers no loss and there is no debit to allocate.
Section 580b bars deficiency judgments after foreclosure of real property that secures many purchase money loans, including all third-party loans to buy owner-occupied residential property with one to four units, such as the marital residence here. See Spangler v. Memel (1972) 7 Cal.3d 603; Prunty v. Bank of America (1974) 37 Cal.App.3d 430; R. Bernhardt, Cal. Mortgage & Deed of Trust Practice (2d ed. 1994 & 1995 supp.) §§4.23 ff. Transactions within the scope of this statute are, in effect, non-recourse loans. Both sides know that the debtor's personal assets, other than the secured property itself, are not liable for the debt. Home-buyers borrow with confidence that their liability is limited, and prudent lenders take care to not to lend more than a reasonably safe fraction of the property's fair market value.
Wife's difficulty here is obvious. He can argue that the loan balance (before close of escrow or foreclosure) is a community debt. But Husband can reply that, after the close of escrow, the deficiency is not a community liability for purposes of netting out the estate. Husband is right. "Liability" generally means an obligation that a party has a legal duty to pay. Before foreclosure or short sale, the community has a legal duty to make the lender whole: a debt. But after foreclosure or short sale, the legal duty ends and the debt is gone.
Legal duty apart, it may be hard to argue that the community has a moral duty to make the lender whole, or that a short sale would impair Wife's standing with Growth. The community invested a down payment to buy real property. The lender invested the amount of the loan to buy an income stream. By law, the community risked only its investment, but the lender's risk was secured by property that it must have believed was worth significantly more than it loaned. The whole amount the community risked is gone. If the property sells short for, say, $265,000, but the community paid 20% down, the deficiency, even after closing costs, will still be relatively small.
Perhaps Wife can show that Growth would probably frown on a deficiency transfer because that would reflect on Wife's judgment (she made a bad investment), detract from Growth's good standing with the lender, or even trigger a guarantee that Growth might have given the lender on the note. Requiring such a guarantee is a standard technique for avoiding §580b. See Heckes v. Sapp (1964) 229 Cal.App.2d 549; Gottschalk v. Draper Cos. (1972) 23 Cal.App.3d 828. See also Bank of So. California v. Dombrow (1995) 39 Cal.App.4th 1457, 1470-1472 (guarantor can waive protection of §§580a, 580d). But see R. Bernhardt, supra, §8.15, at 411 (acknowledging but criticizing rule; "When there is no personal obligation to assume, there is also no personal obligation to guarantee."
Assuming Wife can persuade the court that she has a valid interest in making the lender whole, if not a legal duty, there may be an equitable argument for requiring Husband to contribute to the deficiency. The argument would be that Husband has a stake in Wife's career because the career enables Wife to sustain a high level of spousal support and child support. Cf. Fam. Code §2641(c) (assignment of education loans to the party who used them, without offset, must be modified to the extent circumstances make it unjust; e.g., community has substantially benefitted from loan; education received enables party to earn income that substantially reduces the need for support that would otherwise be required). By analogy, Wife could argue that loan repayment benefits Husband by protecting Husband's ability to pay. Wife could also argue that the best interests of the children require that her ability to support them be protected and enhanced. Both these arguments are certainly stretches.
Even if Wife can make persuasive equitable arguments, he must also persuade the court that it has the legal authority to do what he asks--that is, to debit the community estate with an obligation for which, at the end of the day, it will not be liable. There is no apparent way to make this argument.
CONCLUSION
1. Only a small part of the awards granted to Wife is community property because the grant looks forward only and was made very shortly before separation. Since the awards themselves are not large, the realistic value of Husband's CP share is quite small. The court has discretion to continue the spouses' joint interest in the community shares until they vest and before that time, no real ability to evaluate them accurately. But it seems absurd to keep these bitterly feuding parties tethered by a joint interest in such a small amount. A much more rational approach would be for them simply to assign a present value based on reasonable assumptions and divide that value.
2. Wife's legal position on this issue looks very weak. If she foresees any likelihood of reassignment soon, she might want to consider leasing the house to help carry the payments, charging the community with any shortfall, and hoping that the market will rise again or that Growth will eventually wipe out most of the loss. Or would leasing end Growth's obligation?