Over the past twenty years the landscape of executive compensation has changed markedly.  One new feature is the appearance of executive stock options as a form of compensation.  Stock options are a device by which key employees are granted the right to purchase shares of stock at a given price.  The “option” is to acquire a fixed number of shares of the employer’s stock at the closing price on the date the options was granted.  On the day the options are granted, they have no value because the price of the option stock is equal to the closing stock price that day.  The theory is that as the employees work and improve the state of the company the stock will increase in value.  If I am granted the option to buy stock in my company at $10.00 a share and the stock price goes to $12.00 a share, my option has an intrinsic value of $2.00 per share. If I have 10,000 such options, the options are worth $20,000 before tax. If the price of the stock goes to $20.00, those same options have a value of $80,000.  Options are usually granted so as to vest over three years following the grant.  Once vested, they are usually exercisable for a period of ten years.  These terms can vary based upon the language of the grant.

Alas, the last nine months have not been good to option holders. Many stocks have lost 40% of their value or more.  When the purpose of the option is to incent employees to drive stock prices higher, there is very little incentive to work hard and produce results in a world where the options are exercisable at $10.00 and the stock is trading for $6.00. As the option holder I have to drive the stock price back to $10.00 before the option has any hope of creating value. In some extreme cases options are out there at prices in excess of $50.00 where the stock is trading for less than $10.00.

Hope may be on the way.  The Wall Street Journal reports that companies as diverse as Google, Toll Brothers and Starbucks are developing programs to either re-price or exchange options so that incentives are re-instated. The reason is that two-thirds of public companies have 75% of their options “underwater”; meaning that the options are more expensive than the stock itself and that they have no value.

While these schemes are picking up speed, they are not approaching the level of re-pricing that occurred after the stock market nosedive of 2001. What has changed is that under new accounting rules options need to be reported as expenses by the offering businesses.  This hurts already meager earnings. Second, companies are chary to re-price options until they feel certain that stocks have reached their low ebb.  Otherwise, the incentive is again taken out of the option pricing system.  Finally, some companies are moving away from options in the direction of restricted stock.

The question in a divorce proceeding is whether an exchanged or re-priced option is a post separation asset or a marital asset recast into a new form. Let’s say an employee spouse is granted a series of options just months before separation at $10.00 a share.  After separation the stock drops to $3.00 a share.  The employer decides to redeem the options and substitute the same number of options with a price of $3.00 a share. Are these new options marital? Would it be a different result if the old options were canceled? Suppose the substitute options have a revised vesting schedule?

There is no law on this in Pennsylvania today. There is a reason to try to anticipate this issue and address it in the context of negotiating a property settlement agreement by providing in the agreement that if options are retired and substitute or re-priced options issued, these options should be treated as marital as well. The same principles may be applicable to options granted by a new employer as a device to compensate a new hire for marital options that were left on the table when the employee changed jobs. Again, the law in this regard is not clear, but the point is one that merits discussion in any divorce negotiation.

For more information. Online.wsj.com “Underwater Stock Options Not Dead Yet” 3/18/09; 7:53PM