Saturday, July 17, 2021

Will He or Won’t He?

The business news this week was just lousy with reports on the Tesla trial currently ongoing in Delaware, and in particular, with reports on the testimony of Elon Musk (which, disappointingly, appears to have been less inflammatory than his depositions).  

The basic set up, of course – as I previously blogged – is that Musk championed Tesla’s acquisition of SolarCity, a company he founded with his cousins, chaired, and in which he held a substantial stake.  The unaffiliated Tesla shareholders voted in favor of the deal, which would be enough to cleanse it and restore business judgment review if Musk was not a controlling shareholder, but if he was, entire fairness review would follow.  So one of the burning questions at trial – and the one which most of the news reports focus on – is whether Musk, with something like a 22% stake in Tesla at the time, could be considered a controlling shareholder.  And that question, in turn, focuses not just on his voting power, but on his practical control over the company and the board. 

Y’all know that the question of who is a controller is one that has dominated a lot of my thinking recently (my most recent blog post on the subject is here; earlier posts are here, and here, and here, and here, and here, and here, and here), so I do have to observe that in In re Pattern Energy Group Stockholders Litigation, VC Zurn spent a lot of time explaining how one can be a controller – with fiduciary duties that follow – even without any stock ownership at all.  As she put it:

Fiduciary duties arise from the separation of ownership and control.  The essential quality of a fiduciary is that she controls something she does not own.  A trustee need not (and does not) own the assets held in trust; directors need not own stock. Even a third party lender that influences extraordinary influence over a company may be liable for acting negligently or in bad faith.  If a stockholder, as one co-owner, can owe fiduciary duties to fellow co-owners because the stockholder controls the thing collectively owned, surely an “outsider[]” that controls something it does not own owes duties to the owner.  “[I]t is a maxim of equity that ‘equity regards substance rather than form,’” and “the application of equitable principles depends on the substance of control rather than the form[;] it does not matter whether the control is exercised directly or indirectly.”  “[T]he level of stock ownership is not the predominant factor, and an inability to exert influence through voting power does not foreclose a finding of control.”  Thus, “Delaware corporate decisions consistently have looked to who wields control in substance and have imposed the risk of fiduciary liability on that person,” and “[l]iability for breach of fiduciary duty therefore extends to outsiders who effectively controlled the corporation.”

With this foundation, and considering evolving market realities and corporate structures affording effective control, Delaware law may countenance extending controller status and fiduciary duties to a nonstockholder that holds and exercises soft power that displaces the will of the board with respect to a particular decision or transaction.

That’s a point I made in my essay, After Corwin: Down the Controlling Shareholder Rabbit Hole; as I wrote there:

[O]ne of the first things a business law student learns is that even without a formal equity stake, contractual control can be exerted to the point where fiduciary obligations follow.  But all of this just raises the question whether the shareholder aspect of the controlling shareholder inquiry is necessarily doing any work.

Point being, the fact that Musk’s power does not come from his stock holdings alone is not dispositive of this question.  Musk is the kind of figure that boards, and shareholders, might be afraid to buck because he can’t be dislodged – Musk himself testified that Tesla would “die” without him – and he can send Tesla’s stock price tanking with a single tweet.  Imperial CEOs present a difficult case, but those factors are pretty much the basis for treating controlling shareholders differently from just ordinary conflicted boards. 

Or, with apologies to Guth v. Loft, 5 A.2d 503 (Del. 1939), “Musk was Tesla, and Musk was SolarCity.”  

That said, it must be observed that: (1) Plaintiffs can win this case even if Musk is deemed not to be a controlling shareholder, and (2) it’s possible VC Slights won’t have to decide whether Musk is or isn’t.

More under the cut...

Remember, a lot of the Board had close ties to Musk, and/or their own stakes in SolarCity.  Defendants claim that the Board was nonetheless independent of Musk and disinterested (including, ahem, Musk’s brother, whom defendants describe as having only a “small equity stake” in SolarCity and who did not “automatically defer[]” to Musk but instead “had a history of a completely frank and robust exchange of sometimes contrary views in the businesses in which they worked together”), but, well, let’s just say I’m liking the plaintiffs’ chances of establishing that the Board was not disinterested and independent.  If so, then even if Musk was not a controller, the deal could only be cleansed by an informed stockholder vote, and plaintiffs argue that the full details of SolarCity’s financial condition were not disclosed.  If plaintiffs prevail on that, the transaction is reviewed for entire fairness even if Musk did not “control” in the legal sense. 

(By the way: Neither plaintiffs nor defendants even bother to cite DGCL 144 in their pre-trial briefing; do with that information what you will.)

But what this means is that the question whether Musk is legally a controlling shareholder may turn out to be beside the point.  If VC Slights holds the Board was conflicted and the disclosures inadequate, he can go straight to entire fairness review, substantively analyze the deal and Musk’s role in it, and come to a conclusion without attaching any labels to anything.

Well, sort of.  Because in addition to the derivative claim that Musk caused Tesla to overpay for SolarCity, there is also a direct class claim that Musk – as controlling shareholder – caused Tesla to issue more stock to himself (as overpayment for his own SolarCity shares), thus enhancing his control.  That claim relies on Gentile v. Rossette, 906 A.2d 91 (Del. 2006), and its holding that in this unique context, claims against a controlling shareholder can be brought directly as well as derivatively.  So plaintiffs can only prevail on the class claim if Musk is a controlling shareholder; if not, then even if Tesla did overpay for SolarCity, all claims must be derivative in nature.

But then again.... 

When it comes to the remedies plaintiffs are seeking, they argue that one possible remedy on the derivative claim is to cancel the Tesla shares that Musk received in the deal.  And, they suggest, without directly stating, that a similar remedy would be appropriate on the direct claim.  Which would allow VC Slights to avoid distinguishing between them, which would again make Musk’s status as a controlling shareholder, or not, irrelevant. 

Plus!  Delaware court-watchers know that right now, pending before the Delaware Supreme Court, is Brookfield Asset Management v. Rosson, in which the defendants are arguing that Gentile should be overruled.  I have no idea how that case will come out, but the Delaware courts have increasingly cast doubt on Gentile’s logic and reduced it to something of a vestigial doctrine; it wouldn’t surprise me if Gentile finally got the heave-ho.  And VC Slights, knowing that the question is pending, may take his time deciding the Musk matter until it is resolved.

Which means, there is a very real path for (1) VC Slights to decide this case without deciding whether Musk is a controlling shareholder and (2) plaintiffs to win whether Musk is one or not.

And yet there’s more to consider:

Currently pending before VC Slights are two other derivative cases against Musk, one of which involves his tweeting (currently stayed), the other of which involves his compensation package.  Both allege that he is a controlling shareholder (though legally, only the latter case depends on that characterization).  And yes, of course, the question of control is kind of fact specific depending on the transaction at issue and the point in time when it occurred – Musk could conceivably be a controller in one case and not another – but I bet someone’s going to try to make some kind of an estoppel argument if VC Slights reaches a decision on Musk’s control-status either way.  (Though I note that the Tesla/SolarCity plaintiffs tried, and failed, to get hold of deposition transcripts taken by the compensation plaintiffs, in part because VC Slights ruled that the transactions in the two cases were dissimilar).

Does VC Slights want to decide whether Musk was a controlling shareholder, and guide these other cases?  Maybe.  Would he rather delay that fight for now?  Maybe.  Is it better that companies have more guidance on this issue so they can plan transactions accordingly?  Maybe.  Or is it better, as I argued in After Corwin, that there be some ex ante doubt about controller status so that boards will be strict about cleansing mechanisms?  Maybe.

Finally, it should be noted, no matter what happens in this case, it’ll be appealed, and unless I missed a case somewhere, the Delaware Supreme Court has not yet decided whether the Corwin/MFW cleansing dichotomy applies to controlling shareholder transactions other than squeeze outs.  The Chancery courts are pretty much in agreement that it applies to all conflicted controller transactions (other than, natch, the demand requirement for derivative claims), but the Delaware Supreme Court could hold that for some controller transactions, Corwin is sufficient to cleanse, or even that some controller transactions can’t be cleansed at all (which is what Itai Fiegenbaum argues is the correct rule).  But if VC Slights’s decision doesn’t depend on Musk’s status as a controlling shareholder, the Delaware Supreme Court can save that issue for another day.

Ann Lipton | Permalink


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