Chancellor Kathleen McCormick of the Delaware Court of Chancery grappled with this question in a recent derivative lawsuit challenging Tesla’s performance-based equity award with a potential USD55.8 billion maximum value and USD2.6bn grant date fair value to Tesla CEO Elon Musk (the “2018 Grant”).¹

In a 200-page post-trial opinion, the Court ruled that Tesla’s directors had breached their fiduciary duties in awarding the 2018 Grant. While the 2018 Grant was approved by a majority of disinterested shareholders, the Court concluded that proxy disclosure was deficient and, therefore, shareholders were not fully informed.

The Court found that the defendants – Musk, Tesla, Inc., and six individual directors – failed to meet their burden of proving that the 2018 Grant was “entirely fair”. Underscoring this ruling was the court’s determination that Musk held controlling stockholder status with respect to the 2018 Grant, which made it subject to heightened review under the entire fairness standard.

In entering judgement for the plaintiff-stockholders, the Court ordered rescission of the 2018 Grant in its entirety, implying that, yes, the world’s richest person had indeed been overpaid.

This case stands out for several compelling reasons, serving as a crucial guide on how to avoid pitfalls in executive compensation approval.

Factual background

2018 Grant

On January 21, 2018, Tesla’s Board of Directors (the “Board”) unanimously approved the 2018 Grant, which granted Musk an opportunity to secure 12 tranches of options, each representing 1% of Tesla’s total outstanding shares as of January 21, 2018. The vesting of each tranche was tied to Tesla’s achievement of certain market capitalization and operational milestones. The 12 market capitalization milestones increased in USD50bn increments, beginning at USD100bn and ending at USD650bn. For the 16 operational milestones, eight were based on revenue and the other eight on adjusted EBITDA.

Analysis

The court’s analysis proceeded in the following four parts:

Standard of review

The Court’s analysis first addressed the “gating issue” of which standard of review applied to the 2018 Grant.

The default standard of review applied by Delaware courts to challenges to fiduciary duties is the business judgement rule. The business judgment rule presumes that directors act in good faith with reasonable belief that their actions are in the best interests of the corporation and its stockholders. When the business judgement rule applies, the plaintiffs bear the burden of proving breach of fiduciary duty.

However, when a transaction involves self-dealing with a controlling stockholder, i.e., a conflicted-controller transaction, the heightened standard of “entire fairness” applies in which the fiduciary and not the plaintiff bears the burden of proving that the transaction was a product of fair dealing and fair price.

Whether a transaction is a conflicted-controller transaction depends on whether the stockholder “controlled” the corporation. Following a heavily factual analysis, the Delaware Court of Chancery concluded that because the 2018 Grant was a transaction between Tesla and a controlling stockholder, entire fairness applied. In finding that Musk controlled Tesla in this transaction, the Court took into account:

• Musk’s “enormous” influence over Tesla, characterized by his equity stake of 21.9%;²
• his extensive personal and professional ties with directors who were negotiating on behalf of Tesla (including the members of the compensation committee);³ and
• his domination of the process that led to the board approval of the 2018 Grant.

Standard and burden shifting

The Court then addressed the defendants’ argument that the stockholder vote shifted the burden under the entire fairness standard to the plaintiff, concluding that defendants retained the burden because the stockholder vote was not fully informed.

The Delaware courts have approved a framework that alters the standard of review from entire fairness to the business judgment rule for conflicted-controller transactions if the controlling stockholder conditions the transaction on the approval of a special committee and a majority of minority stockholders. Further, Delaware law allows defendants to shift the burden of proof to the plaintiff where a conflicted-controller transaction is approved by a fully informed vote of a majority of the minority stockholders.

However, in this case, the Court rejected both the standard shifting as well as burden shifting arguments on the basis that Tesla’s independent committee was not independent because of the presence of individuals with extensive ties to Musk, and the stockholders’ vote was not fully informed because the proxy statement pertaining to the vote that ultimately approved the 2018 Grant failed to disclose the following material information:

• “[T]he financial or personal connections between the members of the compensation committee and Musk”;
• “[T]he level of control that Musk exercised over the process—i.e., his control over the timing, the fact that he made the initial offer, the fact that his initial offer set the terms until he changed them six months later, the lack of negotiations, and the failure to benchmark, among other things”; and
• The conversation that Musk had with a director in early April 2017, which represented the first time the 2018 Grant was discussed, and during which “Musk established the key terms of the 2018 Grant.”⁴

The primary consequence of these findings was that the defendants bore the unenviable burden of proving that the 2018 Grant was entirely fair.

Was the 2018 grant entirely fair?

After determining that the defendants bore the burden of proving that the 2018 Grant was entirely fair, the Court applied the two elements of the entire fairness standard of review: fair price and fair process.

Fair process: In observing that the process leading up to the approval of the 2018 Grant was deeply flawed and rushed, the Court noted that despite multiple board, compensation committee, and working group meetings, there was “barely any evidence of negotiations” and “neither the Compensation Committee nor the Board acted in the best interests of the Company when negotiating Musk’s compensation plan,” but instead engaged in a cooperative and collaborative process

Fair price: The Court queried why Tesla Board “never asked the USD55.8 billion question: Was the plan even necessary for Tesla to retain Musk and achieve its goals?” The fact that Musk already had such a significant equity position in Tesla meant that Musk and the Tesla stockholders’ interests were already aligned prior to the 2018 Grant. Further, Musk had made it clear prior to the approval of the 2018 Grant that he had no intention of leaving Tesla, which the Court found discounted any argument that the price was fair as an attempt to retain Musk. The Court found that the lack of any objective benchmarking analysis, the enormous size of the plan in comparison to peer companies, and the lack of ambitious and difficult milestones reflected an unfair process leading to an unfair price.

The Court noted that the 2018 Grant was “the largest potential compensation opportunity ever observed in public markets by multiple orders of magnitude – 250 times larger than the contemporaneous median peer compensation plan and over 33 times larger than the plan’s closest comparison, which was Musk’s prior compensation plan”.⁵

The Court added: “[th]e incredible size of the biggest compensation plan ever – an unfathomable sumseems to have been calibrated to help Musk achieve what he believed would make “a good future for humanity. A good future for humanity is a really good thing. Some might question whether colonizing Mars is the logical next step. But, in all events, that “get” had no relation to Tesla’s goals with the compensation plan”.⁶

Rescission as an appropriate remedy

The Delaware Court of Chancery as a court of equity enjoys broad discretion in fashioning remedies for fiduciary breaches. While noting that a rescission does not automatically follow an uninformed vote, the Court noted it was deemed an appropriate remedy in this case because no third-party interests were implicated by the rescission and the 2018 Grant was “unexercised and undisturbed” in its entirety.⁷

Key takeaways

Although this case was characterized by extraordinary circumstances and notable figures, it underscores critical considerations relevant to executive compensation and board governance.

Below are a few takeaways for corporations considering significant compensation awards.

• Fair price. Rigorous benchmarking analysis, ambitious and difficult milestones, assets and market value, prospects and other economic factors impacting the intrinsic value should be carefully considered.
• Inoculate members of the Special Committee from the controlling shareholder. The slate of independent directors must be carefully identified, and members of the board should be directed to avoid any one-off communications and ensure full disclosure of material relationships and communications with a controlling shareholder. Independence should not only be considered under applicable stock exchange requirements but should also involve a holistic review of historical professional, financial, and personal relationships with the award recipient, as well as the financial position and interests of the directors in the company (as well as other companies owned by the controlling shareholder / executive in question).
• Full and accurate disclosure in proxy statement. Companies must carefully scrutinize their compensation disclosures to ensure that all relevant information about director and executive pay, material relationships, and the approval process are disclosed fully and accurately. When seeking “majority of the minority” stockholder approval, it is imperative that companies furnish comprehensive and unambiguous disclosures to shareholders. This includes the full disclosure of any potential conflicts of interest. Additionally, when detailing the negotiation process, it is crucial to accurately represent all material discussions and meetings pertinent to the negotiations. In matters of director independence, companies should explicitly state the standard of independence applied—such as confirming each director’s disinterest and independence in accordance with the relevant stock exchange criteria. Where feasible, delineating the factors evaluated in determining independence from the award recipient can provide further transparency and assurance to shareholders.
• Implement rigorous process and control timing. Directors should ensure the board retains control over the entire process of approval. Protocols for a sufficient number of meetings to discuss the conflicted transaction within a reasonable timeline must be implemented. The process should be adequately documented in board minutes, internal memos, e-mails, presentations, and other written records.
• Positional and meaningful negotiations. The Board and independent committee must ask relevant questions, examine assumptions, engage independent legal advisors and compensation committees, and negotiate against the controlling shareholder in arm’s length negotiations.

Footnotes

1. See Richard J. Tornetta et al. v. Elon Musk et al., case number 2018-0408, in the Court of Chancery of the State of Delaware.
2. This fact was not dispositive, but the Court found that Musk’s stock ownership gave him a “leg up” because the company also had a supermajority voting requirement for any amendment to the bylaws governing stockholder meetings, directors, indemnification rights, and the supermajority voting requirement itself.
3. The Court noted that only one director was found to be independent, because she had no ties to Musk and had allowed the Tesla options she earned while a director to expire without exercising them.
4. It is worth noting that the Court rejected the defendants’ argument that the disclosure was fully informed because the key economic terms were disclosed.
5. Opinion at 1. In addition, the Court summarily rejected the “Hindsight Defense” since the defendants failed to prove any causation between Musk’s “less than full time” efforts and Tesla’s performance.
6. Opinion at 180.
7. It is also worth noting that the defendants did not offer a viable alternative to rescission. “Once a breach of duty is established, uncertainties in awarding damages are generally resolved against the wrongdoer.” Opinion at 199.
8. The authors would like to thank the invaluable contributions of Brian Jebb, Yuwei Liu and Ardalan Khalafi.