In Re Michener
MEMORANDUM OPINION 1
Before the Court is the Trustee’s Objection to the Debtors’ Exemptions and Motion for the Entry of an Order Compelling Turnover of Property of the Debtors’ Estate pursuant to 11 U.S.C. § 542 and Entry of an Order Declaring Certain Property to be Property of the Debtors’ Estate. The Debtors oppose the relief sought by the Trustee. For the reasons stated below, the Court will sustain the Objection and grant the Motion.
I.BACKGROUND
On July 22, 2004 (the “Petition Date”), John F. and Hope G. Michener (the “Debtors”) filed a petition under chapter 7 of the Bankruptcy Code. George L. Miller (the “Trustee”) was appointed the chapter 7 trustee.
On the Petition Date, Mr. Michener held certain employee stock options (“ESOs”) that had been granted by his employer between February 16, 1999, and August 15, 2003. 2 The Debtors did not report the ESOs on their Schedules and, in response to an inquiry by the Trustee, took the position that the ESOs were not property of the estate. 3 According to the Debtors, the ESOs were not exercisable as of the Petition Date, though 220 became exercisable shortly thereafter, on August 15, 2004.
The Trustee objected to the Debtors’ apparent claim of exemption 4 and sought turnover of the ESOs. A hearing was held on March 17, 2006, on the Trustee’s Objection and Motion. At that time the Trustee argued that all Courts to address this issue have concluded that ESOs become property of the estate whether or not they are exercisable. The Debtors requested time to submit a reply brief on this point, which was filed on March 28, 2006. The Trustee filed a supplemental response on April 4, 2006. This matter is now ripe for decision.
II. JURISDICTION
This Court has jurisdiction over this matter pursuant to 28 U.S.C. § 157(b)(2)(B), (K) & (0).
III. DISCUSSION
A. Property of the Estate
The Trustee argues that the ESOs became property of the estate on the Petition
The Debtors assert that, while Mr. Mi-chener owned the ESOs on the Petition Date, he did not own the right to exercise them at that time. Therefore, they argue, there was no “legal” or “equitable” interest in the
exercise
of the ESOs that could have passed to the bankruptcy estate.
See LDA Acquisition, LLC v. Flag Wharf, Inc. (In re Competrol Acquisition P’ship),
The Debtors’ reliance on Competrol is misplaced. In that case, the Court addressed the issue of whether, under Massachusetts law, the debtor’s option to purchase parking space licenses amounted to a property interest in the licenses such that the owner’s post-petition sale of the licenses to another party violated the automatic stay. Id. at 917. The Court held that it did not. The Court did, however, conclude that the right to exercise the option was property of the estate, thereby entitling the estate to a claim for damages against the owner. Id. at 917-18. Thus, the case does not stand for the proposition that the option or the right to exercise it was not property of the estate, as the Debtors suggest.
The Court agrees with the Trustee and the weight of authority holding that ESOs become property of the estate upon commencement of the case whether or not they are exercisable at that time.
See In re Carlton,
B. Post-Petition “Earnings” Exclusion
The Debtors argue that, even if the ESOs are property of the estate, the right to exercise them constitutes “earnings from services performed by an individual debtor after commencement of the case,” which are excluded from estate property by operation of section 541(a)(6).
The Debtors do not cite (and the Court was unable to find) any authority applying section 541(a)(6) to exempt fully from property of the estate ESOs that were granted pre-petition but became exercisable post-petition. Several Courts, however, have applied section 541(a)(6) and principles of
quantum meruit
to exclude from the bankruptcy estate a
pro rata
share of the realizable value of ESOs that became exercisable post-petition.
See DeNadai,
The analysis first set forth in Allen, and developed further in later cases, may be summarized as follows. ESOs that are not yet exercisable are contingent, unmatured contract rights to receive shares of the employer’s stock upon tender of the option price at a future date and subject to certain conditions. These contract rights become property of the estate upon commencement of the bankruptcy case. See 11 U.S.C. § 541(a)(1). Any profit realized upon exercise of the ESOs post-petition becomes property of the estate as “proceeds ... or profits” of property of the estate (i.e., the contract rights). 11 U.S.C. § 541(a)(6). It does not become property of the estate, however, to the extent it constitutes “earnings from services performed by an individual debtor after commencement of the case.” Id.
If ESOs (1) would not have become exercisable but for the employee’s continuous provision of services for the employer and (2) would have been forfeited by the employee upon termination of his employment, then the employee’s provision of services was a condition precedent to exercise of the ESOs. When an employee’s provision of services for his employer satisfies a condition precedent to an obligation running to him from his employer (e.g., to issue a paycheck or to sell stock at the option price), the fruits of such obligation (e.g., the paycheck or the stock) are “earnings” of the employee within the meaning of section 541(a)(6).
Only earnings from post-petition services, however, are excluded from the bankruptcy estate. 11 U.S.C. § 541(a)(6).
Where ESOs are granted pre-petition, their exercise may be earned by pre-petition and post-petition efforts of the Debt- or. Accordingly, the realizable value of ESOs that become exercisable post-petition (i.e., the spread between the option price and market price of the stock) must be divided between the estate and the Debtor on a quantum meruit basis:
Whatever percentage of the time required for exercise of each group of options had passed before [the Debtor] filed his petition in bankruptcy, that percentage of option value is allocated to the bankruptcy estate. Whatever percentage of the time required for exercise of the options passed after the date of [the Debtor’s] petition in bankruptcy, that percentage of the option value belongs to [the Debtor].
Allen,
In the instant case, for example, the 220 ESOs that became exercisable on August 15, 2004, had been granted 366 days earlier, on August 15, 2003. 6 Mr. Michener’s provision of services for his employer between the grant date and the petition date thus satisfied 93.44% (342/366) of the condition precedent to exercise. His provision of services between the petition date and the date the ESOs became exercisable satisfied the remaining 6.56% (24/366) of the condition. The option price for these 220 ESOs is $29.9621. Accordingly, the option value is ([JPM market price per share] — $29.9621) x 220 shares. 93.44% of that value belongs to the estate and 6.56% belongs to the Debtors under the quantum meruit analysis.
The
Allen
approach was soundly rejected in
Dibiase,
a case relied upon by the Trustee.
The only other reported decision considering these conflicting authorities agreed with
Dibiase. Carlton,
a. “Proceeds” of Property of the Estate
According to
Dibiase,
the
Allen
Court erred first by “confusing the future
value
of a given stock option with the estate’s present
interest
in the option.”
Dibiase,
The mere fact that some of an asset’s eventual value might be affected by post-petition events, however, should not of necessity affect the independent determination of whether the estate owns all or only a portion of an asset.
... [I]n the [Allen] court’s view, the debtor’s post-petition actions add or create value post-petition, such that the debtor “earns” or “creates” not just the value of the option but a portion of an interest in the option (called by the Allen court “realizable value”) by continuing to be employed. Indeed, this notion of “earning” is reinforced when the Allen court suggests that some portion of the Option may actually represent some species of post-petition earnings.
... To make the logic work, the [Allen] court suggests that the debtor “earns” the right to exercise the option, and that this “exercise” is some species of property independent of but somehow growing out of the underlying option — a kind of “proceeds of property” attributable to the Debtor’s individual post-petition services (i.e., his continued employment) .... For that conclusion to stand, the option must be both the property of the estate and the proceeds of itself (because the earnings exception in 541(a)(6) applies only to proceeds of property of the estate). The logic does not work. The option cannot be both the property that comes into the estate on the date of filing and the proceeds of itself.
Id. at 683-84 (citations omitted, emphasis in original).
This Court disagrees with the
Dibiase
Court on this point.
Allen
need not be read to stand for the absurd proposition that an ESO is “proceeds of itself.” The opinion makes clear that
“upon exercise
the present value of the options ... must be divided” between the Trustee and the Debtor.
Allen,
It is true that, by ordering the Debtor to turn over to the Trustee a percentage “of his rights” in the unexercised ESOs, the
Allen
Court seemed to conclude that only a portion of the ESOs became property of the estate.
See
This Court agrees with the analysis of the
DeNadai
Court that ESOs “are first and foremost property of the estate” and that the Trustee, not the Debtor, should decide whether and when to exercise them.
See
b. “Earnings” of the Debtor
The
Dibiase
Court also criticized the
Allen
Court’s conclusion that part of the profits from exercise of the ESOs constituted post-petition “earnings” of the Debtor. According to the
Dibiase
Court, this “essential error” in reasoning stemmed from “confusion over the difference between conditions precedent and conditions subsequent.”
Dibiase,
The Allen court evidently thought that the exercise provisions in the stock option agreement operated as a kind of vesting mechanism, so that the debtor “earned” options by staying employed— a kind of condition precedent. In fact, however, the agreement in Allen ... provided that the option ... may be forfeited if the employee ceases to be employed — a condition subsequent.... The grant is immediate, but it is subject to revocation. [ESOs] may be subject to revocation or reduction in the future, but they are not earned simply because the employee stays employed ....
Id. (emphasis in original).
This Court disagrees with the
Dibiase
Court on this point as well. Nothing in section 541(a)(6) compels reference to outmoded distinctions between conditions precedent and subsequent to determine whether proceeds of estate property constitute “earnings from services performed” by the Debtor post-petition. Indeed, there is a “general consensus that the distinction between conditions precedent and subse
To illustrate, suppose an employer promises on Monday to issue two paychecks on Friday: one to Employee A
“if
he performs services during the week” (a condition precedent) and the other to Employee B
“unless
he fails to perform services during the week” (a condition subsequent). Both employees work all week and both receive their paychecks on Friday. There is no
substantive
difference between the paychecks; both would be considered “earnings from services performed” during the week. It strains common usage to suggest that Employee A “earned” his paycheck throughout the week but Employee B “earned” his paycheck fully on Monday. Yet this is precisely the result reached by the
Dibiase
Court, which concluded that an ESO “has its full value on the day it is granted” even though it may never become exercisable (e.g., if the employee quits or is terminated).
Dibiase,
This conclusion simply does not square with economic reality. A non-exercisable ESO has no “value” apart from the possibility that it may become exercisable, thereby obligating the employer to issue stock at the option price. If this depends upon the Debtor’s continuous employment, then the increase in value when the ESO becomes exercisable results — literally-—■ “from services performed” by the Debtor. It does not matter whether the performance of such services satisfies a condition precedent, or merely prevents the occurrence of a condition subsequent, to the employer’s obligation to issue stock at the option price. Either way, the realizable value of the ESOs is directly attributable to the Debtor’s efforts.
See Litzler v. Sholdra (In re Sholdra),
For these reasons, the Court declines to follow
Dibiase
and
Carlton.
The term “earnings” is certainly broad enough to include the profit realized from the exercise of an ESO.
See Sholdra,
Proration also strikes a sensible balance between “the dual purposes of the [Bankruptcy] Code: first, to maximize the creditors’ recovery and second, to provide the debtor with a fresh start.”
Allen,
IV. CONCLUSION
For the reasons stated above the Court will sustain, in part, the Trustee’s Objection to the Debtors’ exemption and grant the Trustee’s Motion for turnover of the ESOs. The Debtors shall turn over the ESOs to the Trustee, who shall, upon exercise of the ESOs, turn over to the Debtors their pro rata share of the value realized pursuant to the Allen formula. The Debtors shall also provide the Trustee with a full accounting of all ESOs held by Mr. Michener on the Petition Date, which shall include the terms and conditions of the grant, the grant date, the exercise price, and the date each ESO became (or is anticipated to become) exercisable. To the extent Mr. Michener has exercised any ESOs that were property of the bankruptcy estate, 8 the Debtors shall turn over to the Trustee the estate’s pro rata share of the value of these ESOs under the Allen formula, calculated using the higher of the current market value of JPM stock or its market value at the time of exercise.
Notes
. This Opinion constitutes the findings of fact and conclusions of law of the Court pursuant to Federal Rule of Bankruptcy Procedure 7052, which is made applicable to contested matters by Federal Rule of Bankruptcy Procedure 9014.
. The ESOs were issued by Bank One, which subsequently merged with JPMorgan Chase ("JPM”). A September 11, 2004, summary of Mr. Michener’s JPM ESO account shows that Mr. Michener had been granted a total of 5,306 ESOs pre-petition, of which 2,598 remained outstanding as of the date of the summary. (Debtors’ Supp. Br. Ex. B.) It is not clear, however, if that is the number of outstanding ESOs Mr. Michener held on the Petition Date.
. The Court notes that Schedule B requires disclosure of "all personal property of the debtor of whatever kind” whether or not it is property of the estate.
. The Trustee also objected to other exemptions claimed by the Debtors (including Mr. Michener’s 2004 employment bonus and tax refund). Those objections have been resolved.
.
Allen
and
Lawton
were discussed at length in
Dibiase
and
Carlton,
cases relied upon by
. 2004 was a leap year.
. Discussion of
DeNadai
on this point was conspicuously absent from the
Dibiase
opinion.
See Dibiase,
. The Debtors' Supplemental Brief cryptically states: "By September 11, 2004 [i.e., 51 days after the Petition Date] Mr. Michener had previously exercised 2488" ESOs.