Friday, September 27, 2019
There is a lot going on in VC Slights’s new opinion in Tornetta v. Musk, refusing to dismiss a shareholder suit challenging Elon Musk’s eye-popping compensation package.
In Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014) (“MFW”), the Delaware Supreme Court held that, in the context of a squeeze-out merger, controlling shareholders can obtain business judgment review – rather than entire fairness – if they employ the dual protections of requiring the affirmative vote of a majority of the disinterested shares, and requiring that the deal be negotiated at the outset by a fully-empowered independent board committee.
Since then, there have been a lot of questions about MFW’s application, including whether MFW can/should be employed beyond the context of squeeze outs, which brings us to Tornetta.
Last year, Tesla granted Elon Musk a new compensation package that would award him as much as $55 billion in Tesla stock options, conditioned on achieving certain milestones. The package was approved by a vote of the unaffiliated Tesla stockholders, but did not satisfy the full set of MFW preconditions (i.e., it was not negotiated by an independent committee, etc). Thus, Tornetta filed a lawsuit challenging the award on the ground that (1) Musk is a Tesla controlling shareholder (2) the award is therefore an interested transaction subject to review for fairness and (3) the award was unfair. The claims were brought both directly and derivatively.
Now, the first interesting thing about this case is the number of issues that could have been raised on the motion to dismiss, but were not (though defendants may still raise them later).
Defendants could have, but did not, dispute that Musk was a controlling shareholder (likely because VC Slights previously concluded he was in a case challenging the Tesla/SolarCity merger – I’ll come back to that).
Defendants could have, but did not, dispute that the directors who approved the package were dependent on Musk.
Directors could have, but did not, move to dismiss for failure to make a demand on the board (more on that below).
Directors could have, but did not, move to dismiss on the ground that the claim could not be maintained as a direct action (again, more below).
As a result, the narrow question before Slights was simply whether stockholder approval alone can cleanse a compensation award to a controller, or whether instead MFW procedures are required. And he held that MFW procedures are always required when a controller’s interests conflict with those of the minority.
[More under the jump]
In his opinion, Slights presents this as something akin to a question of first impression: whether controller transactions must always receive either MFW cleansing or entire fairness review, or whether instead the dual protections of MFW are only required to cleanse those transactions that cannot be accomplished without shareholder and director approval in the first instance (like mergers). But in fact, this question has already been asked and answered at the Chancery level. See In re Ezcorp Inc. Consulting Agreement Derivative Litig., 2016 WL 301245 (Del. Ch. Jan. 25, 2016) (MFW applies to any transaction where a controller receives a non-ratable benefit, including conflicted consulting payments); IRA Trust FBO Bobbie Ahmed v. Crane, 2017 WL 7053964 (Del. Ch. Dec. 11, 2017) (endorsing the use of the framework for all “transactions involving controllers”).
Still, Slights’s opinion represents an incremental step forward, as executive compensation to a natural person controller is far more mundane than the types of transactions to which MFW has previously been applied. Slights recognized as much; as he put it:
I do agree with Defendants that nothing in MFW or its progeny would suggest the Supreme Court intended to extend the holding to other transactions involving controlling stockholders. That does not mean, however, that MFW’s dual protections cannot provide useful safeguards here. .... With MFW’s dual protections in place,... the minority stockholders have far less reason to fear that the controller will retaliate if the committee or minority stockholder votes do not go his way.
He also modified MFW somewhat. Recognizing that MFW has been interpreted to mean that a majority of the outstanding disinterested shares must approve a controller transaction before it can be cleansed, he held that when it comes to matters that do not require approval of the outstanding shares as a legal condition of consummation, a majority of voting disinterested shares will be sufficient. (See fn. 128)
So, what to make of this?
To begin, the choice was not really between MFW and business judgment (due to shareholder ratification). The choice was between MFW, business judgment, and entire fairness no matter what Tesla did. The law on conflicted controllers has been muddy for a long time, but until MFW was often summarized as requiring that all controller transactions receive entire fairness review. That’s why, in the wake of MFW, Itai Fiegenbaum argued that entire fairness should be the rule – even with MFW procedures in place – for less than transformative transactions. See Fiegenbaum, The Controlling Shareholder Enforcement Gap, Am. Bus. L.J. (forthcoming). Fiegenbaum claims that in a squeeze out kind of transaction, all eyes are on the controller, there’s a real likelihood of litigation, and that scrutiny coupled with MFW procedures may protect minority stockholders. But in more ordinary transactions, that frequently will need to be brought derivatively and thus satisfy the demand requirement, controllers know that the chance of litigation is slight. Therefore, they won’t even bother with MFW cleansing, and by offering it as an option, courts paper over the failures in our mechanisms for policing conflicted controllers.
Nonetheless, Slights – and other Chancery judges – have coalesced around requiring MFW cleansing for all conflicted-controller transactions; otherwise, entire fairness review will apply.
What are the implications?
Well, there seems to be general agreement that the one exception to such a rule will be the demand requirement for derivative litigation, which means that for most claims, even entire fairness review will not lead to excessive litigation because plaintiffs will not be able to show that demand would be futile (exactly Fiegenbaum’s point). I.e., the law will assume that independent directors cannot objectively consider whether to grant the controller certain benefits, but will assume they can objectively consider whether to sue the controller for receipt of those benefits. As bizarre as it sounds, no one is disputing that is the law as it stands, and, as a result, Slights’s extension of the MFW framework to ordinary executive compensation may not generate as much litigation as would seem at first glance.
But that didn’t stop the plaintiff in the Tornetta case, partly because the defendants did not challenge on demand grounds, and partly because the plaintiff brought his claim directly as well as derivatively, on the theory that an undeserved stock award to a controlling shareholder is both a direct and derivative harm under Gentile v. Rossette, 906 A.2d 91 (Del. 2006).
Is that right? As far as I can tell, it’s not clear. Just recently, VC Zurn held that compensation awards are not subject to the Gentile rule. See Reith v. Lichtenstein, 2019 WL 2714065 (Del. Ch. June 28, 2019). Plus, Klein v. H.I.G. Capital, L.L.C., 2018 WL 6719717 (Del. Ch. Dec. 19, 2018), held that preferred stock awards do not fall within Gentile because they may not ever be converted into common. I figure similar logic might be applied to contingent options awards (does anyone know if there’s any definitive caselaw on that?)
In any event, defendants never argued the claims were not direct – they stuck solely their argument that shareholder ratification was sufficient to cleanse (and a claim that the award was fair, which, c’mon, was never going to be decided on the pleadings) – so we didn’t get an answer. But questions about Gentile’s scope will be hanging out there in future cases, especially when boards are more distant from their controllers than the Tesla board.
That said, even if we assume that the practical impacts of Slights’s rule are constrained by the procedural requirements of derivative claims, the rule still contributes to the general confusion in this area if only because there is so little clarity regarding the definition of a controlling stockholder in the first instance. The more that controller transactions are sharply differentiated from other transactions, the greater the importance of identifying who the controllers actually are, and right now, that question is mired in confusion – which itself will generate a lot of litigation, as well as indeterminacy regarding board responsibilities.
This was a point I made when Slights first held that Musk might be deemed a controller in connection with a challenge to the SolarCity acquisition. There, unaffiliated shareholders approved the deal but it was not negotiated by an independent committee. If Musk was not deemed a controlling shareholder, any challenge to the acquisition would be dismissed due to shareholder ratification under Corwin; if he was deemed a controller, however, the deal would be subject to entire fairness review. Musk only held around 22% of Tesla’s stock, and mostly seemed to control the company by virtue of his importance and his relationship to the directors – just like a lot of imperial CEOs. Nonetheless, Slights held that plaintiffs had sufficiently alleged that he was a controlling stockholder to survive a motion to dismiss. At the time, I said:
We can call this yet more Corwin fall out: by heightening the significance of the stockholder vote only for transactions that fall into a specific category, the Delaware Supreme Court wound up placing pressure on the boundaries of that category.
That prediction has borne out as the Tesla/SolarCity litigation continues. The plaintiffs got past the motion to dismiss by claiming Musk was a controller; information uncovered during discovery, however, suggests that significant details about SolarCity were withheld from shareholders when they approved the merger. As a result, the plaintiffs have moved for partial summary judgment, and in their briefing, they make no arguments about the special scrutiny applicable to controlling stockholder deals, and instead argue only that the omissions in the proxy nullified the effects of any shareholder vote under Corwin. In other words, the controlling shareholder inquiry served as a stalking horse to get past Corwin’s pleading hurdles, and now, with access to discovery materials, the plaintiffs don’t need it anymore.
I have since written a whole essay on the problem, forthcoming in the Vanderbilt Law Review, After Corwin: Down the Controlling Shareholder Rabbit Hole. As I argue there, “Courts reviewing deals that would be cleansed under Corwin may therefore be incentivized to put a thumb on the scales in favor of a controlling-shareholder finding when the conduct at issue appears particularly egregious.” I posted the first version of that paper back in May and I just put up a revised version. The changes are pretty minor (so if you read the earlier one you shouldn’t feel obligated to read the new one), but I do want to highlight what I now say in the conclusion:
Delaware’s difficulties in dealing with controlling shareholders are not new; inconsistencies and ambiguities go back for decades. But the combination of Corwin, C&J Energy, and MFW have spotlighted those doctrinal fissures by requiring courts to draw artificially sharp distinctions between control and noncontrol transactions when in fact control exists on an increasingly-nuanced spectrum. The distance between the legal inquiry and the factual reality may be unsustainable; in time, we may expect either a relaxation of Corwin – as courts draw more inferences of control or find other ways to evade its strictures – or, perhaps, a tightening of MFW, if the Delaware Supreme Court continues down the path it began in Corwin by narrowing the definition of control in the first place.
Given Slights’s acknowledgment that his Tornetta ruling expands MFW, the case seems like a good candidate for an interlocutory appeal, at which time at least some of these issues could be resolved.