Rocky Mountain Mediation Bulletin Board

DETERMINING AND VALUING

CONTINGENT MARITAL INTERESTS

IN COLORADO

MIRIAM E. MASON

SESSUMS, MASON & BLACK P.A.

30 6 7 SOUTH MAGNOLIA AVENUE

TAMPA , FL 33606-2337

(813) 251-9200

RESEARCH PROVIDED BY:

INGRID ANDERSON

Prepared: December 1999

MIRIAM E. MASON

Miriam graduated from the Cumberland School of Law, cum laude , in 1975. She received the rating of AV by Martindale Hubbell, and has held numerous positions with the Florida Bar. She served on the Bar's Long-Range Planning Committee. Her roles in the Family Law Section of the Florida Bar were as Executive Council, Education Chairperson, Secretary/Treasurer, Chair-Elect and ultimately, Chair. Miriam has also been a Fellow of the American Academy of Matrimonial Lawyers since 1983. She served as President of the Florida Chapter; and on a national level, the Board of Directors, Secretary and Treasurer, a three-year Vice-Presidential term, First Vice-President and President-Elect. Miriam became President of the American Academy of Matrimonial Lawyers in November 1999. She is also a Master of the Bar in the Justice William Glenn Terrell Inns of Court. Miriam has been named in the Fifth through the Eighth editions of The Best Lawyers in America . She is a Diplomate of the American College of Family Trial Lawyers.

DETERMINING AND VALUING

CONTINGENT MARITAL INTERESTS

I. TYPES OF MARITAL INTERESTS

a. STOCK OPTIONS

In Miller v. Miller , 915 P.2d 1314 (Co. 1996), The Supreme Court of Colorado held that vested stock options were subject to distribution if issued for past performance or if issued for future performance and a portion of the future services had been performed. The Supreme Court redefined the term “ vesting ” (for purposes of an analysis of marital interests and not as defined by the particular stock option or restricted stock plan or agreement ) as occurring when the employee has completed the minimum terms of employment necessary for the employee to be entitled to receive the benefits, whether or not the benefit had a readily ascertainable value or was subject to a substantial risk of forfeiture . In other words, the stock options are vested if the rights under the option cannot be unilaterally repudiated by the employer even though the ability to exercise the option is contingent on the passage of time and continued employment. Determining whether the stock option is vested as defined by the Miller opinion is the first step in analyzing whether any portion of the stock option is marital.

The second step in analyzing marital interest in a stock option is to determine whether the vested stock option was granted in consideration for past or future services. The extent of the spouse's enforceable rights under the option agreement depends on the extent to which the options are granted in consideration of past or future services. To the extent an option is granted in consideration of future services, the employee has not earned the compensation for such services and does not have an enforceable right under the option agreement until such time as the future services have been performed. An employee stock option granted in consideration of future services does not constitute marital property until the employee has performed those services. A vested stock option may contain components which were issued in consideration for past services and may contain components issued in performance for future services. A portion of those future services may have, in fact, been performed between the date of issue and the date of dissolution of marriage and, thus, constitutes marital property.

The Supreme Court in Miller rejected the formula method used by the trial court for d ividing etermining the marital portion of the stock options. That formula was “based on the ratio of the period that the parties were married during the respective options and grant ed in proportion to the entire length of the options or grant”. The Supreme Court held that such a formula inherently determined that all of the stock option was granted in consideration of future services. The Supreme Court remanded the case to determine whether any of the stock options were granted in consideration of past services and instructed the trial court to utilize a formula which takes that fact into consideration.

The appellate court in In Re: the Marriage of Huston , 967 P.2d 181 (Co. App. 1998) interpreted the Supreme Court's Miller decision and reversed and remanded the trial court's decision regarding stock options. The trial court had classified the stock options as marital property; whether vested or non-vested, and awarded husband 25% and wife 75%. The Huston court rejected the trial court's determination that any stock option granted in consideration of past performance or past services was marital property even if not yet vested. It appears that the trial court may have misinterpreted the Miller case and the Huston appellate court may have misinterpreted the trial court.

It appears that the Huston appellate court confused the definition of “vesting” for Colorado marital asset purposes and “vesting ” pursuant to the stock option plan. Per a stock option plan vesting occurs when the employee has completed the minimum term of employment necessary for him or her to be entitled to exercise the option.

The trial court in Huston failed to determine whether the stock options were vested. This is a necessary first step according to Miller because if the stock option is not vested it is merely an expectancy and is not property at all. However, in defense of the trial court, it would seem that any stock option granted in consideration for past services would necessarily be vested according to the marital asset definition in Miller . In fact, the second step in Miller (determining to what extent a vested stock option constitutes marital property) is dependent on to what extent the stock option was granted for past services. In other words, if the stock option is not enforceable at all, it would not seem to be possible for it to be enforceable to the extent of the past services.

The substantive error by the Huston trial court was that it did not hold that vested stock options issued for future services may have constituted marital property if a portion of those future services had been performed prior to the dissolution of marriage. Again, in defense of the Huston trial court, the trial court may have considered that fact and included those “performed future services” as being encompassed by the term “past services”. Nevertheless, the appellate court reversed the trial court's decision for a proper rendering in light of its interpretation of the Miller case. See also In Re: The Marriage of Sim , 939 P.2d 504 (Co. App. 1997) [to the extent an employee's stock option is granted in consideration of past services, the option may constitute marital property, citing Miller ].

The Huston trial court also divided division of the stock options 25% to the husband and 75% to the wife . The appellate court did not dispute that such an unequal division was possible was not addressed by the appellate court . The Miller court did not address this issue.

In terms of whe ther n stock options are included as income for the purposes of determining child support, the answer lies in whether or not the stock options were exercised. Proceeds received by the father from the actual exercise of his stock options was ordinary income for the purposes of determining child support, while potential income to be received for the exercise of future stock options was not. In Re: The Marriage of Campbell , 905 P.2d 19 ( Co. App. 1995). [This was a post-dissolution proceeding and the decision does not state whether the stock options existed at the time of the dissolution of the marriage - and therefore had been a consideration in the distribution at the time of dissolution.]

The Colorado appellate court applied the “time-rule” formula to distribute the marital portion of stock options in In re the Marriage of Balanson , 1999 WL 515774 (Colo. App. 1999). The court found and the parties agreed that the options had been granted for future services and as an incentive for husband's continued services. Husband would be available to exercise some of the options 11 days after the permanent orders hearing, and others in increments thereafter. Even though those options were not “vested” pursuant to the stock option plan definition the court found that “….additional options were vested and were marital property to the extent that the services entitling husband to exercise certain options at a later date had been performed prior to the entry of the decree.” While the court didn't specifically say what the formula was - they did point out that In re Marriage of Hunt, 909 P.2d 525 (Colo. 1995) had adopted in this state the “time-rule” formula to divide pension benefits in dissolution of marriage actions.” It is therefor assumed that's the formula to use.

b. RESTRICTED STOCK

This is a question of fact and the same process would be followed as with stock options. In Miller v. Miller , the Supreme Court of Colorado also held that restricted stock shares were marital property because they were awarded for the performance of past services. Language contained in the restricted stock agreement suggested that the agreement was based on consideration of both past and future services. The agreement's grant of authority to the husband to exercise ownership rights in those s tructu ha res was inconsistent with that suggestion. The restrictive stock agreement indi indi cated that restricted stock shares were subject to forfeiture during the five years after the date of the agreement but the employer could not unilaterally repudiate the husband's right to retain the stock. Husband's receipt of the shares was not conditional, and the shares represented a form of deferred compensation even though his enjoyment of the benefit was conditioned on his remaining an employee. That condition can be considered in valuing the restricted stock shares but not in determining whether they are marital property.

c. PENSIONS

Colorado has considered vested pension interests marital property for several years. See In Re: The Marriage of Grubb , 745 P.2d 661 ( Co. 1987) [vested but unmatured interest in a private employee/employer sponsored pension plan considered marital] and In Re: The Marriage of Gallo , 752 P.2d 47 ( Co. 1988) [vested and matured interest in a military pension held to the marital]. In In Re: The Marriage of Kelm , 912 P.2d 545 (Co. 1996), the Supreme Court of Colorado held that both civil service retirement system (CSRC), as well as Colorado's public employees' retirement association (PERA) vested but unmatured interests were subject to distribution. Both plans had characteristics of defined contribution and defined benefit plans. See also In Re: The Marriage of James , 950 P.2d 624 (Co. App. 1997) [PERA plan valued using net present value approach]. Unvested military pensions also have been considered marital property. In Re: The Marriage of Beckman , 800 P.2d 1376 ( Co. App. 1990) and In Re: The Marriage of Hunt , 909 P.2d 525 ( Co. 1996).

d. WORK IN PROGRESS OTHER CONTINGENT ASSETS AND LIABILITIES

1. CONTINGENCY FEES

In In Re: The Marriage of Vogt , 773 P.2d 631 (Co. App. 1989), the Colorado Court of Appeals held that jurisdiction could be reserved to distribute husband's interest in contingent attorney fee awards which were not converted into an account receivable during the marriage. Citing In Re: The Marriage of Gallo , supra, the court approved the reserve jurisdiction method for valuing vested but unmatured contingency payments. The court considered the contingency fees deferred compensation earned during the marriage but payable after dissolution.

2. ACCOUNTS RECEIVABLE

In In Re: The Marriage of Bayer , 687 P.2d 537 (Co. App. 1984), the Colorado Court of Appeals held that accounts receivable represented debts for services already rendered and that the husband's estate would be entitled to them upon his death. Consequently, they constituted marital property. The court did reduce the value of the receivables by 10% as provided in the partnership agreement. The Bayer court specifically held that the Moss decision did not hold that receivables were not subject to valuation, but that the Moss decision merely indicated that the breadth of the trial court's discretion when considering the valuation and distribution of shareholders' interests in a professional corporation . In Moss v. Moss , 549 P.2d 404 (Co. 1976), the Supreme Court of Colorado held that accounts receivable representing services rendered but not yet paid for should be considered in valuing a professional practice, even when a specific value on that corporation was not made. medical practice, even though the trial court had not found the practice to have a specific value. Interestingly, the husband's unvested retirement benefits were included as an interest in his corporation. See also In Re: The Marriage of Sjerven , 820 P.2d 1198 (Co. App. 1991) [in valuing a business or professional practice, the trial court must consider both the tangible and intangible assets including the accounts receivable, the value of work in progress and goodwill].

In Skeff v. Skeff , 523 P.2d 473 (Co. App. 1974), the Colorado appellate court affirmed the trial court's finding that it was not satisfied that the accounts receivable could not be collected, at least in part, and ordered that the accounts be made the subject of an accounting with final disposition to follow after reasonable efforts had been made to collect them. The appellate court affirmed the retention of jurisdiction with respect to the accounts receivable.

3. CONTINGENT LIABILITY ON COMMERCIAL PAPER

In Skeff v. Skeff , supra., the appellate court also affirmed the trial court's retention of jurisdiction to determine whether a loss would be incurred on discounted commercial paper. A number of retail installment sales contracts had been sold to various commercial lenders with the provision for full recourse against the business should the customer default on his payments. Appellant asserted that there existed a contingent liability with respect to this discounted commercial paper and that the valuation of the business should have been reduced accordingly. The trial court stated that from the evidence it had no way of determining any loss on contingent liability and directed that jurisdiction be retained to determine that loss at a time when the amount of the contingent liability was fully resolved.

4. GUARANTEED FOOTBALL CONTRACT

In In Re: The Marriage of Anderson , 812 P.2d 419 (Co. App. 1990) , the Colorado appellate court held that payments which were received on a guaranteed installment contract which was received during the marriage was not future income and was marital property subject to division. However, payments to be received after dissolution of marriage constituted future income and were not marital property.

5. WORK IN PROGRESS

a. MEDICAL PRACTICE

In In Re: Marriage of Piper , 820 P. 2d 1198 (Co. App. 1991), the appellate court held that “in valuing a business or professional practice, the trial court must consider both the tangible and intangible assets, including the accounts receivable, the value of work in progress and goodwill.” (emphasis added). The Piper court specified “accounts receivable” as separate from “work in progress” but addressed only the accounts receivable citing In Re: Marriage of Anderson , 811 P. 2d 419 (Colo. App. 1990) (professional sports contract); In Re: Marriage of Vogt , 773 P. 2d 631 (Colo. App. 1989) (contingent attorney fees); In Re: Marriage of Bayer , 687 P. 2d 537 (Colo. App. 1984) (contingent attorney fees); and In Re: Marriage of Johnson , 40 Colo.App. 250, 576 P. 2d 188 (1977) (real estate commissions).

b. LAW FIRM

Similarly, in Cohen v. Quiat , 749 P. 2d 453 (Co. App. 1987), a partnership agreement provided that upon withdrawal a partner would receive his share “in the net realizable value of accounts receivable and work in progress of the partnership as determined by the policy group [the firm's partners and business manager].” Both the policy group and the arbitrator in this case focused only on the accounts receivable, disputing whether the plaintiff was entitled to a share of receivables generated by himself or by all of the firm members. Nothing in the opinion addressing the meaning of “work in progress” apart from “accounts receivable.” Compare , International Business Machines Corp. v. Charnes , 601 P. 2d 622 (S.Ct. Co. 1979) [court addressed the issue of the application of usage tax to the value of “work in progress” and sales inventories rather than to “full goods cost” or “capitalized costs”, deciding to apply the tax to “work in progress and sales inventories”. Work in progress included the cost of materials and components and partially finished products used for testing, quality control and research and development purposes.]

c. REAL ESTATE COMMISSIONS

In In Re: Marriage of Johnson , 576 PO . 2d 188 (Co. App. 1977), the appellate court held that real estate commissions for which the husband provided the necessary services, needing only to await the completion of the transactions before the commissions materialized, constituted marital property. The court reasoned that the husband would have had a right to the commissions had the husband died prior to the completion of the transactions.

II. CONSIDERATIONS AND COMPONENTS OF VALUE

The Colorado Supreme Court in Miller outlined the primary considerations in determining whether stock options and restricted stock constituted marital property, relying on substantial previous case law involving retirement cases, specifically, In Re: The Marriage of Grubb , 745 P.2d 661 (Co. 1987); In Re: The Marriage of Gallo , 752 P.2d 47 (Co. 1988); In Re: The Marriage of Hunt , 909 P.2d 525 (Co. 1995); and In Re: The Marriage of Kelm , 912 P.2d 545 (Co. 1996). Therefore, this analysis provides the guidelines for determining whether any contingent interest is marital and to what extent. However, the Miller court distinguished stock options from pension benefits in that stock options may be compensation for future services as well as for past and present services, whereas pension benefits are presumed to be in consideration of past and present services, i.e., deferred compensation. The court differentiated conditioning the receipt of benefits on the employee remaining in the employ of the employer (often applicable in pension cases) from providing benefits in consideration of the performance of future services.

The first consideration discussed was whether the interest (or assets) constituted property, as opposed to an expectancy. The court defined an expectancy as not property because the holder has no enforceable rights. The court also designated an expectancy as a non-vested interest, whereas a vested interest was property which could not be unilaterally withdrawn or repudiated by the employer, even though the employee did not have the ability to exercise his interest which was dependent on his continued employment and the passage of time. The court specifically held that vesting occurs when the employee has completed the minimum terms of employment necessary for the employee to be entitled to receive the benefits, whether or not the benefits had a readily ascertainable value or were subject to a substantial risk of forfeiture, which were the criteria for defining vesting pursuant to the Internal Revenue Code. The critical factor for the Supreme Court in Miller was whether the interest could be withdrawn unilaterally, not whether certain conditions were required to be fulfilled, if those conditions were within the employee's power to fulfill. Restricted stock was treated as deferred compensation entirely because it was issued for past performance, even though the restricted stock was subject to forfeiture for five years because the employer could not unilaterally repudiate the husband's right to obtain the stock.

Once the court decided that an interest is property, the court must decide whether that property is marital. The court held that the extent an employee's stock option is granted in consideration of past services, the option may constitute marital property when granted. On the other hand, an employee's stock option granted in consideration of future services does not constitute marital property until the employee has performed those future services. In terms of the restricted stock, the court held that because the employee's enjoyment of the benefits was conditioned on his remaining an employee the value of the restricted stock shares would be effected, not their marital nature.

a. INDICATORS OF COMPENSATION FOR PAST OR PRESENT SERVICES

The Supreme Court in Miller identified several factors which would indicate whether property was given in exchange for past or present services. However, neither the language of the restricted stock agreement nor the testimony of the employer is dispositive. Id. The identification of a specific service for which a grant is awarded is one sign of an award for past services. For example, the trial court in Miller found that the restricted stock shares were granted in return for service on a two year project. Other factors the court noted were:

•  The authority to “exercise ownership”, presumably including the right to vote the shares and the right to receive dividends;

•  The inability of the employer to unilaterally repudiate employee's right to retain the stocks;

•  The employee's receipt of the shares; and

•  Lack of a conditional right to receive shares.

The Miller court cited two out-of-state cases In Re: The Marriage of Hugg , 201 Cal. Rptr. 676 (Ca. App. 1984) and In Re: The Marriage of Short , 890 P.2d 12 (Wa. App. 1995). Those cases mentioned the following factors regarding whether stock option awards were for past or present services:

•  use of awards as an alternative to fixed salaries, in order to obtain optimal tax treatment (making such awards comparable to fringe benefits, health benefits and profit-based incentives);

•  use of awards as bonuses;

•  use of awards as profit-sharing arrangements;

•  use of awards to attract key personnel or to entice them to leave other companies;

•  use of awards as salary alternatives by small or distressed companies that might not otherwise attract top employees;

•  the extent to which the stock option plan is susceptible to modification, which diminishes the emphasis on incentives and future services as factors; and

•  use of options to reward employees;

In Re: The Marriage of Hug , 201 Cal. Rptr. 676 (1984).

•  use as inducement to accept employment;

•  front-loading of the stock options; and

•  persuasion of the employee to accept employment instead of forming a competing computer technology business.

In Re: The Marriage of Short , 890 P.2d 12 (1995).

The Colorado Supreme Court in Miller specifically disapproved the formula used by the trial court because it treated all of the stock options as if they had been awarded for future services, indicating the importance of determining whether the above-referenced factors were present.

While testimony by a spouse's employer that the interest is granted for future services is relevant, that evidence is not dispositive. Miller . The Short decision indicated that plan documents and contracts may be persuasive. The Hugg and Short decisions also suggest the following factors indicate that options were granted for future services:

•  any features that emphasize providing incentive for future employment and future productivity; and

•  motivation for performance resulting in higher stock prices, thus making the share options more valuable.

Generally, the key factor Colorado courts consider is whether the interest was acquired in exchange for services rendered during the marriage . See In Re: The Marriage of Bayer , 687 P.2d 537 (Co. App. 1984) [accounts receivable represent a debt for services already rendered and which husband's estate would be entitled to upon his death and thus constitute marital property]; and In Re: The Marriage of Vogt , 773 P.2d 631 (Co. App. 1989) [attorney contingency fees are not mere expectancies but are valuable contract rights acquired during the marriage and as such are a part of the marital estate].

•  VALUATION METHODS

The three primary methods of valuation are:

•  Net present value;

•  Deferred distribution; and

•  Reserved jurisdiction.

See In Re: The Marriage of Kelm , 912 P.2d 545 ( Co. 1996) and In Re: The Marriage of Hunt , 909 P.2d 525 ( Co. 1996).

a. NET PRESENT VALUE

1. Pension Plans

Net present value is immediately distributing the present value of the pension and offsetting it against other property in the marital estate. This method would be appropriate where the risks of forfeiture of the pension were sufficiently remote to make the determination of a present value in distribution to the non-employee spouse equitable. In valuing the pension such contingencies must be evaluated. In defined contribution plans the present value would be the total of the employee's contributions. The employees' contributions vest immediately and the value of the account is readily ascertainable, since a separate account is maintained for each employee. See Kelm . See also, In Re: The Marriage of Casias , 962 P.2d 999 (Co. App. 1998) [the court need not consider future appreciation of a 401K plan]; and In Re: Marriage of James , 950 P.2d 624 (Co. App. 1997) [present value cannot be reduced by social security equivalency].

In In Re: The Marriage of James , 950 P.2d 64 (Co. Appeal 1997), the court specifically noted that the application of a subtraction method, subtracting the present value of the pension at the time of the marriage from the present value at the time of dissolution was inequitable. The length of the marriage is a significant factor in determining the marital share of the pension and that method gave the wife a grossly disproportionate share of the husband's pension because the enhancement of ultimate retirement pay may be most dramatic at a particular point in the spouse's employment .

2. VALUATION METHODS OF UNVESTED STOCK OPTIONS

There are two components to the value of a stock option:

(1) the intrinsic value which is the difference between the stock value and the exercise price or the price at which the option holder can purchase the stock. Since there is no obligation to purchase the stock, intrinsic value can never be less than zero. The intrinsic value of a stock will always either be positive or zero;

(2) the time value of a stock option is the present value of the expected difference between the value of the stock at the option's expiration date and the options exercise price. If an appraiser knew the future value of the stock as of the options expiration date, the appraiser could merely compute the present value to determine the options value. The appraiser would subtract the stock's value as of the expiration date from the option exercise price and discount the difference back to a present value and an appropriate discount rate. Since the appraiser does not know the future value of the stock, the results of this approach could produce a wide range of estimated values for an option because it depends on the appraiser's determination of the two critical independent variables, i.e., the estimate of the stock value at the options expiration date and the appropriate discount rate to use.

As a result of these problems, economists, especially in the investment field, have devised various methods to determine a present value of stock options. Alternative option valuation approaches have been developed over time and can be classified into three general groups:

(a) Econometric Models - Econometric Models represent a statement of a functional relationship that uses regression analysis of historical relationships between economic variables to estimate statistically the expected value of an economic variable. Accordingly, the historical observed relationships are used to predict what the current market price of an option/warrant contract might be, given current values of the independent variables incorporated in the model and the assumption that the relationship between the variables and the value of the option were stable over time.

(b) Theoretical Models - Theoretical Models are forward looking and attempt to determine what the option/warrant should sell for in the market, given the option's terms and the characteristics of the underlying stock. One of the key features of these models is that they estimate the possible future price of the underlying stock using a normal bell-shaped probability distribution.

(c) Market Approach - The Market Approach is a valuation technique in which market value is estimated based upon the relationship of the market prices of publicly traded securities to certain underlying fundamental security characteristics (i.e., strike price [price for which you can purchase the stock], expiration date [date the right to exercise the option and buy the stock expires], etc.). This method requires the compilation of data related to securities having characteristics similar to the options being appraised. The terms related to these securities are then examined in relation to the option being appraised.

The big question is whether or not only the Econometric Models and Theoretical Models should be used.

Statement of Financial Accounting Standards (FAS) No. 123 establishes financial accounting and reporting standards for stock-based employee compensation plans. It defines a fair value-based method of accounting for an employee stock option or similar equity instrument and encourages all entities to adopt that method of accounting for all of their employee stock compensation plans.

FAS No. 123 confirms their definition of fair value of an asset is:

...the amount at which the asset could be bought or sold in a current transaction between willing parties, that is, other than in a forced or liquidation sale. Quoted market prices in active markets are the best evidence of fair value and shall be used as the basis for the measurement, if available. If quoted market prices are not available, the estimate of fair value shall be based on the best information available and the circumstances. The estimate of fair value shall consider prices for similar assets and the results of valuation techniques to the extent available in the circumstances. Examples of valuation techniques include the present value of estimated expected future cash flow using a discount rate commensurate with the risk involved, option pricing models, matrix pricing, option-adjusted spread models, and fundamental analysis. [Paragraph 9].

FAS 123 also states:

The objective of the measurement process is to estimate the fair value, based on the stock price at the grant date, of stock options or other equity instruments to which employees become entitled when they have rendered the requisite service and satisfied any other conditions necessary to earn the right to benefit from the instruments (for example, the exercise of stock options or to sell shares of stock) restrictions that continue in effect after employees have earned the right to benefit from their instruments, such as the inability to transfer vested employee stock options to third parties, affect the value of the instrument actually issued and therefore are reflected in estimating their fair value. However, restrictions that stem directly from the forfeitability of instruments to which employees have not yet earned the right, such as the inability either to exercise a non-vested option or to sell non-vested stock, do not affect the value of the instruments issued at the vesting date and their effect, therefore, is not included in that value. Instead, no value is attributed to instruments that employees forfeit because they failed to satisfy specified service or performance-related conditions. [Paragraph 17].

Therefore, they established the valuation method as follows:

The fair value of a stock option (or its equivalent) granted by a public entity shall be estimated using an option-pricing model (for example, the Black-Scholes or a binomial model) that takes into account as of the grant date the exercise price and expected life of the option, the current price of the underlying stock and its expected volatility, expected dividends on the stock (except as provided in Paragraphs 32 and 33) and the risk-free interest rate for the expected term of the stock (Paragraph 19).

From a public entity's point of view, or the issuing corporation's point of view, this method may be an acceptable approach in determining an approximate value of all these options they award and, therefore, the appropriate amount of expense to be footnoted on their financial statements. The issue for us to determine is whether or not this approach accurately determines the value of the stock options in the hands of the employee.

The problem to our employee-client is that the various models that have been formulated to appraise stock options (Econometric Models and Theoretical Models) are to appraise publicly traded stock options instead of the employee stock options which have various restrictions. For instance, most option models assume that the employee-optionee is a risk neutral investor and, therefore, employ a “risk-free interest rate” in its computation. Therefore, this model assumes that this average investor can hedge his portfolio of stock options by the use of selected derivative instruments to offset his investment in the security underlying his option position. Most of the employee stock optionees have options that are not tradable and, in fact, many of the corporations specifically prohibit an employee optionee to use exchange traded listed options and specifically the “married” strategy to hedge their position and diversify their portfolio.

If various of the models are used, such as the modified Black-Scholes Model or the modified binomial distribution model to value the employee stock options, what they would have valued is stock options as if the employee can control them and as if they are marketable. Many believe that those models and the value they create do not indicate fair market value because it does not taken into consideration the various “control” and “marketability” restrictions placed upon the employee optionee. Many believe that discounts should be taken from the option values for the following considerations:

•  lack of control considerations;

•  securities law consideration;

•  quantification of governance to issue discounts;

•  marketability discount considerations.

Unreported decisions have indicated that the Black-Sholes method, does not appear to be an accurate method for valuing employment issued stock options in a marital context. Murray v. Murray , 1999 WL 55693 (Oh. App. 1999); Chammah v. Chammah , 1997 WL 414404 (Superior Court, Conn. 1997); and Wendt v. Wendt , 1998 WL 161165 (Superior Court, Conn. 1997); see also Miller v. Miller , supra, [the trial court utilized a deferred distribution method because present valuation of stock options was so difficult].

The trial court in the Wendt case made some interesting observations concerning the Black-Sholes method. The court stated:

The Black-Scholes model is complicated.

. . .

The Black-Scholes method is well known. It is found in commercially available computer software and in a number of publications. Calculators are sold with the formula already programmed so option traders can punch in the variables. Though well known, it does not appear easy to use.... It appears to a layman to be one of the most complicated formulas ever devised by mankind. It is hardly useful for a court to consider with a simple calculator on the bench. It would require expert computation. The plaintiff's expert agreed with the following conclusion by Nobel laureate Professional Paul Samuelson on the Black-Scholes model: it is a ‘modern option pricing technique with roots in stochastic calculus and is often considered among the most mathematically complex of all applied areas of finance.' At a recess this court asked the plaintiff's stock and financial expert to prepare a Black-Scholes calculation. In a fifteen minute trial recess the expert was not able to complete the necessary calculations. There is no doubt that this expert would be able to complete the calculations given adequate time since he did have the appropriate charts, graphs, technical information, variables, givens, formula and calculation equipment. (at Page 195).

The difficulty in the present value method is that, although an unvested stock option may have an intrinsic value (the difference between the market price and the value of the stock option when granted), the market price on the date the option is exercised is extremely difficult to predict. Intrinsic value does not take into consideration any increase in the stock market price that may occur in the future between the date of issue and the date the option is exercised. Deferred distribution and time rule method avoid these difficulties.

New York applied another method of defining contingent resources which was referred to as the “Discount to Present Value Method.” It used a variety of discounts to obtain a present value starting from the intrinsic value. The expert applied three discounts to the intrinsic value: (1) for risk of forfeiture; (2) for a lack of marketability; and (3) for the tax due upon the sale of the underlying stock. Evans v. Snyder , 197 A.D. 2d 389, 603 N.Y.S. 2d 740 (App. Div. 1993).

In determining the net value of accounts receivable, in In Re: The Marriage of Bayer , 687 P.2d 537 (Co. App. 1984), the court reduced the value of receivables by 10% as provided in a partnership agreement and an additional 10% for uncollectibility. An additional amount was also discounted to compensate husband for income tax consequences. On the other hand, in Skeff the court retained jurisdiction to determine the amount of accounts receivable actually collected.

b. DEFERRED DISTRIBUTION

The deferred distribution method entail require s that the trial court de vis termin e the non-employee's percentage share in the pension asset in advance of receipt of the benefits. The non-employee's share is determined by applying the “time rule formula” (established by the Colorado Court for pension plan cases) if and when the benefits are received. The time rule formula incorporates a “coverture fraction” which comprises a numerator, the credible length of time of credible service toward the pension accumulated during the marriage over the denominator, the length of total employment until actual receipt of the benefits. The coverture fraction is then divided in half, representing an equal division of the pension benefits:

Years of service during marriage

= X monthly benefit X one-half

Years of total service

See In Re: Marriage of Hunt . Using this method, post-dissolution increases in pension benefits are marital property and would be subject to division. Colorado has adopted the “marital foundation” theory in that enhanced pension benefits due to increases in rank or length of employment are acquired during the marriage if distribution is delayed . See In Re: The Marriage of Hunt . Reserved jurisdiction method works like the deferred distribution method in this regard. However, if the pension is distributed under the net present value method, post-dissolution enhancements essentially are treated as separate property. Any contingencies underlying actual commencement of retirement should be taken into account in selecting the methodology to be used in distributing the pension not whether the pension is included in the marital estate. Id.

In reference to valuing stock options , the Supreme Court in Miller required the following analysis:

•  Findings as to whether each option was granted for past or future services.

•  Division of the portions granted for past services.

•  A determination of an appropriate means of evaluating the portions that reflect compensation for future services.

•  Division of such portions found to be marital.

The Supreme Court disapproved of the particular time rule formula used to divide the stock options because it treated all the stock options as if they were issued for future services. The formula used by the trial court was based upon the ratio of the period that the parties were married during these respective options in proportion to the entire length of the options. However, in Hug v. Hug , 201 Cal.Rptr. 676 (1984), a different time rule formula was used, which would probably be more acceptable to the Miller court, i.e., numerator = period between commencement of spouse's employment by the employer and the date of separation of the parties over denominator = period between commencement of employment and the date when each option is first exercisable, x number of shares which can be purchased on the date the option is first exercisable. The Hug court noted that the time rule formula is not fixed and may be adjusted for each circumstance . Don't get caught up in using a formula just because it exi s ts. Many courts from other states use different formulas. For example,

•  A fraction, the numerator of which will be the total number of days between the assigning or granting of the option agreement and the date of separation, the denominator of which will be the total number of days from the signing or granting of the option agreement and the date on which each portion of the option became fully vested and not subject to divestment. The ratio created by such fraction will be divided into the gain on the stock option on the date of exercise to determine the community property interest thereof after reimbursement for the purchase of the option in any taxes paid thereon. Harrison v. Harrison , 225 Cal. Rptr. 234 (Ct. App. Cal. 1986).

•  The numerator was the number of months from the date of the grant of each block of options to the day of the couple's separation, while the denominator was the period from the time of each grant to its date of exercisability. Nelson v. Nelson , 222 Cal. Rptr. 790 (Ct. App. Cal. 1986).

•  The number of months from the date of the option grant to the date of dissolution divided by the number of months from the date of the option grant to the date of vesting.

Multiplying the number of shares in each stock option by that fraction, the trial court awarded the wife the opportunity to exercise purchase options as the options vest on those shares. Powell v. Powell , 934 P. 2d 612 (Ct. App. Ore. 1997).

Make sure you analyze the specific asset and it's characteristics and the purposes it was given to the employee spouse. While the Miller court did not specify a particular formula to substitute, it ordered the trial court to devise one. The trial court retained jurisdiction to distribute the property when the options were exercised because of the difficulties in determining the present value of the stock options.

The time rule formula has been used extensively in Colorado 's retirement cases and could be adopted to fulfill the Supreme Court's Miller requirements. In In re the Marriage of Balanson , 1999 WL515774 (Colo. App. 1999), specifically found that the trial court must devise a method to distribute the marital portion of the options and may apply the “time-rule” formula to distribute the marital portion of the options . Later in the opinion the Balanson court noted that the “time-“rule formula has been adopted in this state to divide pension benefits in dissolution of marriage actions. Application of that “time-rule” for requirements, such as treating mula would treat the options as relating to the entire period of employment until vesting. The marital percentage would be the period of employment during the marriage (the numerator) divided by the period of employment from hire until vesting (the denominator). Time rule formulas usually require the court to retain jurisdiction over the case.

One issue which was not addressed by the Miller Supreme Court decision, but which wife had asserted at trial, was whether she would be able to force the exercise of the marital options once their waiting period had expired. However, in Green v. Green , 494 A. 2d 721 (Md. App. 1985), the court found that the husband could not be compelled to exercise his option. See also In Re: The Marriage of Frederick , 578 NE2d 612 (Ill. App. 1991) [wife asked the trial court to retain jurisdiction so that she could petition the trial court to compel husband to exercise her share of the option at her expense, but the court refused]; compare Callahan v. Callahan , 361 A.2d 561 (NJ 1976) [Court upheld constructive trust in favor of wife's 25% interest in stock options. Husband was to follow wife's instructions regarding sale.]

c. RESERVED JURISDICTION

Reserved jurisdiction permits a trial court to wait until the benefits are actually received and to divide them at that time. This last method allows If the court doesn't determine a specific formula to apply at the time of the later division this method would allow the trial court the flexibility to consider any changes in circumstances that have transpired during the interim period between dissolution and receipt of benefits. At that time the court would have to hear the evidence to make it's determination. If the court were to reserve jurisdiction on numerous contingency fees without a predetermined formula - there may be many mini-trials.

The reserved jurisdiction method was cited in In Re: The Marriage of Vogt , 773 P.2d 631 (Co. App. 1989), for use with contingency fees in the legal practice when the court stated that “one method approved by our Supreme Court for the division of vested but unmatured contingency payments is the reserve jurisdiction method, which allows the trial court to determine the division formula at the time of the decree to retain jurisdiction to distribute payment when the contingent funds are received”. In Skeff v. Skeff , supra , the court retained jurisdiction to determine whether commercial paper should be discounted, as well as to determine the actual amount of account receivables collected.

Indicators of compensation for past or present services was taken from “Employee Stock Options and Restricted Shares: Determining and Dividng the Marital Plot” by Thomas P. Malone, 25 Oct. CoLaw 87.

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