Keeping Stock Options in Bankruptcy Depends on This Key Factor

Are Unvested Stock Options subject to a Chapter 7 Bankruptcy liquidation? Ninth Circuit case law clarifies.

Unvested stock options aren’t very common, but if someone gets compensated with contingent stocks, they can be worth a lot of money.  Keeping the unvested stock options in a Chapter 7 bankruptcy liquidation, then, becomes critical.

Stock Options and Property of the Estate

Stocks and the Bankruptcy Code: Section 541

The first place to start is determining whether stocks or stock options are property of the estate.  Looking at 11 USC 541(a)(1), we see that “Except as provided in subsections (b) and (c)(2) of this section, all legal or equitable interests of the debtor in property as of the commencement of the case.”

So, when the bankruptcy gets filed, whatever the debtor owns at that time is property of the estate and subject to possible liquidation.

Stocks: Vesting versus Unvested

What is the difference between vested and unvested stocks or stock options? Vesting is the process of earning an asset. The process is scheduled, and can be based on time, achievements, or both.

So, vested stock is that which is owned free and clear, and has full control of. The employee can do whatever they want with vested stock. Vested stock is theirs to sell, cash out, move into another account, or give to their cousin Lucy. Vested stock cannot be taken by the employer or company.

Unvested stock is not yet owned, and is still unearned. Unvested stock or contingent stock options are not that of the employee, or in this case, the debtor. It is still contingent on time-based schedule, some milestone, or both. The worker has no right to it, and the contingent unvested stock is forfeited if the employee leaves the company.

Unvested Stock and Chapter 7 Bankruptcy

Chapter 7 bankruptcy and contingent stock

The distinction between unvested stock and vested stock (or stock options) is key, especially in a Chapter 7 bankruptcy. Why? Because in Chapter 7 bankruptcy, assets are subject to be taken and used to pay some or all of the debtor’s liabilities. In contrast, Chapter 13, like a debt repayment plan, does not take assets to repay debts.

Exemptions and stock options

There is some ability to protect stocks and stock options called exemptions.  Exemptions are what each state allows people to protect and save in a Chapter 7 bankruptcy from being taken away from them. In California, there is no specific non-retirement stock exemption, or stock option exemption (retirement accounts are generally protected). Therefore, the only way we can generally exempt stocks or stock options is under the 703s and the wild card exemption.

Look at the employment contract. Find out exactly what it says about how and when the stock is earned. Because, now we turn to timing.

Ninth Circuit Case Law on Stock Options and Bankruptcy

When are Exemptions Determined

First, when is the point of measuring the value of the stocks or stock options? Is it the total value of the stock package, earned or unearned?  Is it set when the person started working? At the time of the trustee questions under oath at the 341(a) meeting of creditors? At any point before bankruptcy discharge? Or something else?

A debtor’s exemptions have long been fixed at “the date of the filing of the [bankruptcy] petition.” Wilson v Rigby, 909 F3d 306 (9th Cir 2018), citing SCOTUS’ White v Stump, 313, 45 S.Ct. 103 (1924), and, locally, Wolfe v. Jacobson, 676 F.3d 1193, 1199 (9th Cir 2012).

There it is. Exemptions are determined at filing with the so-called snapshot rule.

So what are the stocks worth at filing?

If the employment contract or compensation package has words like “contingent” and “unvested,” that implies there is no value in the present, until some postpetition event occurs.

Which Stocks are Subject to Liquidation

The Ninth Circuit Court of Appeals has weighed in on the exact issue as to when and which stocks can be sold to repay creditors in a bankruptcy.  Meet Larry Ryerson.

Mr. Ryerson was a manager at Farmer’s Insurance, and had an employment contract. Part of the contract was to pay him a value which turned into almost $20,000 upon some future event. Mr. Ryerson years later filed Chapter 7 bankruptcy.  About 10 months after filing bankruptcy, an event happened entitling Ryerson to the still-unpaid money.

The 9th Circuit looked at whether the contract and value was property of the estate, and then also determined whether the $20,000 was.

It found in this case that the condition that would cause the contract to vest had occurred, and was the property of the estate, as it was a “legal or equitable interests of the debtor in property as of the commencement of the case.”

However, the Ninth Circuit then held that its ruling does not necessarily mean that all of the money is subject to liquidation. It was a case where a portion of a debtor’s prepetition contingent interest was includable in the bankruptcy estate, even where the interest vested postpetition, because the debtor’s interest in the property was sufficiently rooted in the pre-bankruptcy past.  In re Ryerson, 739 F. 2d 1423, (9th Cir 1984).

“The Bankruptcy Appellate Panel determined that only the debtor’s interest at the time of bankruptcy is property of the estate; any interest attributable to post-filing services was expressly excluded from the estate. We agree. Section 541(a)(6) excludes from the estate ‘earnings from services performed by an individual debtor after the commencement of the case’.” Id. at 1426.

Applying this to stock options, the right to earn and collect stock based upon some future condition exists at the time of filing, and should be disclosed on the list of assets, Schedule B.  If the stocks were vested, then they are subject to liquidation (and exemptions). If the benchmark or condition has not been achieved at time of filing, then, according to Ryerson, it would seem the value of the future stock is unvested and zero, particularly any interest attributable to postpetition work, which would be excluded per Section 541 at (a)(6).

On the other hand, if like some real estate sales or realtor commissions, they are still unpaid but attributable to prepetition work, then those would be property of the estate and not excluded by 541a6.

Like with the bankruptcy means test, timing in bankruptcy is everything.