Plaintiff Ryan McAfee and defendant Metropolitan Life Insurance Company ("MetLife") dispute the value of plaintiff's performance-based stock options for purposes of calculating his monthly disability benefits. On November 17, 2008, the matter was tried to the court, sitting without a jury. The following memorandum constitutes the court's findings of fact and conclusions of law pursuant to Federal Rule of Civil Procedure 52(a).
I. Factual and Procedural History
Plaintiff was Vice President of Research at PeopleSoft Inc. in Pleasanton, California. (Defs.' Resp. to Pl.'s Undisputed Facts 2:3-7.) On October 3, 1999, plaintiff was injured in a fall resulting in the paralysis of the lower half of his body. (Pl.'s Resp. to Def.'s Undisputed Facts 2:6-9; Compl. ¶ 8.) Despite his injury, plaintiff continued to work remotely from his house in Canton, Ohio, from December 1999 to June 2001. (Supp. Admin. R. ("SAR") 3044.) He then moved back to California in June 2001 and "worked alternately 2-3 days a week from home and 2-3 days a week in the Pleasanton office." (Id.) However, due to the physical and mental strain involved, plaintiff stopped working on May 7, 2002. (Id. at 3045, 3416.)
Plaintiff filed a claim for Long-Term Disability ("LTD") benefits pursuant to PeopleSoft's employee benefit plan, which was funded and administered by MetLife (id. at 3051-54) and governed by the Employee Retirement Income Security Act of 1974 ("ERISA"), 29 U.S.C. §§ 1001-1461. Plaintiff began receiving payments in November 2002, but MetLife subsequently terminated plaintiff's benefits due to a lack of evidence supporting a "continued disability" as defined by the plan. (SAR 2782-83.) Plaintiff appealed the decision; he argued that he not only qualified for LTD benefits, but also that MetLife was underpaying him by not considering his performance-based stock options in calculating his payment amount. (Id. at 2782-83.)
After plaintiff's appeal, MetLife reinstated plaintiff's LTD benefits but rejected his view that the LTD- benefit calculation should include performance-based stock options. (Id. at 3048.) Under the plan, LTD benefits were based on a claimant's "predisability earnings," which were defined as "gross salary or wages from [the] Employer as of the day before . . . Disability began," including "commissions and/or performance bonuses averaged over the previous 12 months." (Sullivan Decl. Ex. A at 86.)
Plaintiff filed suit under 29 U.S.C. § 1132(a)(1)(B) (Docket Nos. 1, 4), which provides for civil actions to recover disability benefits under an ERISA plan. In its Order dated May 23, 2006, the court concluded that the term "performance bonuses" in the plan "clearly encompasses the incentive stock options at issue here, . . . and that [MetLife's] interpretation to the contrary was unreasonable." (May 23, 2006 Order 12.) The court subsequently remanded the case to MetLife in order to recalculate plaintiff's LTD benefits. (Id. at 14.)
On July 6, 2006, plaintiff's counsel wrote a letter to MetLife with the following proposal to determine the value of plaintiff's stock options:
The income earned from the stock options is reflected on [plaintiff's] W-2 forms as ordinary income and on the Schedule D as long-term capital gain income. The best evidence of the earnings from the stock options are [plaintiff's] W-2's and income tax return/Schedule D for the relevant period. (SAR 3302.) This proposal yielded "predisability earnings" of $568,540.26, which included plaintiff's base salary of $175,315.44 and earnings from the exercise of stock options totaling $393,224.82. (Id. at 3418.) According to the terms of the plan, these "predisability earnings" would result in a disability payment of $25,000 per month, less plaintiff's receipt of Social Security income. (Id. at 3302.)
MetLife consulted two experts in order to respond to plaintiff's proposal and calculate plaintiff's benefit payments. The first expert was Daniel Skwire, a principal and consulting actuary at Milliman Inc. (Id. at 3398.) In Mr. Skwire's report, he discussed at length his belief that stock options were not covered by PeopleSoft's employee benefit plan. (See generally id. at 3398-3410.) Mr. Skwire ultimately concluded, however, that "[i]f MetLife is required to determine benefits . . . as if stock options were included in Predisability Earnings, then it should consider only the option value of stock options granted in the 12 months prior to disability and not the ensuing income pertaining to exercises of those options." (Id. at 3400.)
Mr. Skwire believed that "performance bonuses averaged over the previous 12 months" did not refer to stock options exercised during that period because employees have complete control over when they exercise their options. In other words, plaintiff's proposal would create a "moral hazard." (See id. at 3404-05 ("The moral hazard problem is the tendency of individuals to alter their behavior because of insurance. . . . [T]he insurance itself provide[s] an incentive for the insured to try to collect the benefits." (quoting Kenneth Black & Harold D. Skipper, Jr., Life and Health Insurance (13th ed. 2000)).) In contrast, Mr. Skwire stated that interpreting the plan to refer to stock options granted did not create a moral hazard "because the granting of options is controlled by the employer, not the employee." (Id. at 3405.)
The second expert consulted by MetLife was M. Chapman Findlay, Ph.D. At the time of his report, Dr. Findlay was the president and director of Fin Fin Inc. and had previously held positions as Professor and Chairman of the Department of Finance and Business Economics at the University of Southern California. (Id. at 3389-90.) Dr. Findlay's analysis essentially followed two steps: (1) identifying the relevant stock options and (2) applying the Black-Scholes model to determine their value.
a. Identifying the Relevant Stock Options
Like Mr. Skwire, Dr. Findlay rejected plaintiff's proposal to calculate disability payments using the stock options exercised during plaintiff's final twelve months at PeopleSoft. Instead of addressing the "moral hazard" issue, however, Dr. Findlay explained that "exercise occurs at the holder's discretion and has no necessary relation to contemporaneous performance." (Id. at 3367.) Dr. Findlay continued, "This is somewhat similar to putting each year's bonus check in a drawer, cashing 5 or 6 at once (except this year's), and claiming that to be this year's bonus." (Id.)
Dr. Findlay proceeded to review the stock options granted during plaintiff's last twelve months at PeopleSoft, which spanned from May 7, 2001, to May 6, 2002. (Id.) Plaintiff received 12,500 option-shares on May 11, 2001; 20,000 option-shares on January 4, 2002; and 12,000 option-shares on April 15, 2002, which together totaled 44,500 option-shares. (Id. at 3368.) Dr. Findlay found this number concerning: "This figure is more than twice the 20,000 [plaintiff] claimed to receive on average . . . . As shown in the table, the average [for] 1995-2002 appears to be more like 16,000." (Id.) Accordingly, Dr. Findlay first decided to exclude the 12,500 shares granted in May 2001, explaining,
[G]iven his disability contentions, it is hard to imagine that the awards from 1999 onward were for "superior performance." It has been suggested that the company was rewarding him for dealing with his problems and/or that the position carried a basic option package (which might vary from year to year on profit and performance). . . .
Under the latter construction, it would appear that either by accident or "gaming," two years' worth of grants are represented in the 44,500 and the 2001 grant should be dropped. (Id.)
Dr. Findlay then turned to the options granted in January and April 2002, and again noted that "[g]iven the declaration of disability . . . it seems unlikely that this was a period of accelerating superior performance." (Id. at 3369.) Further, Dr. Findlay observed that during this time, PeopleSoft's stock price fell by roughly one-half and that the April 2002 grant approximated the corresponding decrease in the value of the January 2002 grant. (Id. at 3368, 3540.) Accordingly, he found it would be reasonable to "assume . . . that the 12,000 share grant . . . in April was a defacto repricing of the January grant without bothering to cancel it." (Id. at 3369.)
By eliminating the May 2001 grant and considering the April 2002 grant a "defacto repricing," Dr. Findlay arrived at "a range of 12,000-20,000 shares." (Id.) He selected the midpoint of this range, 16,000 option-shares, which corresponded to the average number of option-shares granted per year from 1995 to 2002. (Id. at 3368, 3369.)
b. Applying the Black-Scholes Model
After identifying the relevant stock options, Dr. Findlay proceeded to apply the Black-Scholes model to value them. As Dr. Findlay explained, the Black-Scholes model is essentially a formula that considers several variables in order to determine the value of a stock option. (See id. at 3370.) In applying the Black-Scholes model, Dr. Findlay made certain assumptions regarding (1) the volatility of the underlying stock and (2) special restrictions on employee stock options ("ESOs") as compared to typical stock options.
Since the holder of a stock option can determine when to exercise it, options "are only exercised when 'in the money' . . . . Hence, . . . options increase in value as risk [(i.e., volatility)] increases." (Id.) Under the Black-Scholes model, a stock option can be valued by calculating the volatility of the underlying stock with reference to the stock's historical prices. (See id. at 3372.)
Dr. Findlay concluded, however, that the use of PeopleSoft's historical data was inappropriate for measuring volatility. He found that PeopleSoft's historical data did not "conform to any of the stochastic processes assumed in the [Black-Scholes] model." (Id.) In other words, there was no positive correlation between the volatility of the stock and its future price; when volatility peaked, "the stock invariably fell." (Id.) Dr. Findlay also contended that tempering the value-enhancing effect of PeopleSoft's volatility was appropriate because volatility suggests "a large . . . probability of firm failure." (Id.) Accordingly, Dr. Findlay "assume[d] representative values for volatility": a value of 0.3 representing average risk, and a value of 0.5 representing "very high risk near the bounds of instability." (Id.)
Using the stated, ten-year maturity on plaintiff's stock options, Dr. Findlay applied both the 0.3 and 0.5 volatility measures to each of plaintiff's twelve stock-option grants occurring between March 31, 1995, and April 15, 2002. (Id. at 3375.) This yielded two prices for each stock-option grant. (Id.) He averaged the prices for each level of volatility across all of the stock-option grants to arrive at values of $9.10 per share and $11.70 per share, respectively. (Id. at 3378.)
ii. Special Restrictions on ESOs
After obtaining these prices, Dr. Findlay discussed special restrictions on ESOs that can decrease their value. Specifically, employees cannot sell or hedge their ESOs, they can only exercise them; due to this characteristic, "there is little dispute that ESOs are worth less than the simple [Black-Scholes] value." (Id. at 3376.) After reviewing a 2004 presentation to the Financial Accounting Standards Board ("FASB"), Dr. Findlay concluded that these restrictions on ESOs reduced their value by roughly forty to fifty percent. (See id.)
Dr. Findlay multiplied the average prices ($9.10 and $11.70 per share) by 16,000 option-shares and obtained $187,200 and $145,600, respectively. After discounting these values by forty to fifty percent in light of the special restrictions on ESOs, he averaged the results, yielding $74,000. (Id. at 3378.) According to MetLife's plan, this value would provide an additional $3700 to plaintiff's monthly benefit payment. (Id.)
In a letter dated October 13, 2006, MetLife rejected plaintiff's proposal to calculate his LTD benefits based on the stock options he exercised during his final twelve months of employment. (Id. at 3415-20.) Instead, MetLife adopted Dr. Findlay's calculation of plaintiff's LTD benefits. (Id. at 3419-20.) MetLife also relied on Mr. Skwire's report to explain its decision. (Id. at 3418.)
Citing Mr. Skwire's report, MetLife first rejected plaintiff's proposal by asserting, "Even if 'predisability earnings' under the Plan were interpreted to include awards of stock options as 'performance bonuses,' under the plain meaning of the Plan, the 'bonus' would be the award of the option, not the sale of the stock." (Id.) Accordingly, to calculate plaintiff's predisability earnings, MetLife stated it "must determine the value of the performance-based stock options awarded in the 12 months preceding the last date worked." (Id.)
MetLife proceeded to explain Dr. Findlay's analysis. First, MetLife noted that plaintiff received 44,500 option-shares during his final twelve months at PeopleSoft; however, MetLife observed that this was "the final year before [plaintiff] declared that he was disabled from working, raising questions about whether he was capable of performance so exceptional in that year that he ...