Thursday, February 1, 2024
So, anything interesting happening in corporate law this week?
I kid, I kid. On Tuesday, Chancellor Kathaleen McCormick of the Delaware Court of Chancery issued her long-awaited opinion in Tornetta v. Musk, where she took the extraordinary step of holding that Elon Musk’s Tesla pay package from 2018 was not “entirely fair” to Tesla investors, and ordered that it be rescinded. In practical effect, she ordered the cancelation of stock options worth about $51 billion, or, according to news reports, about a quarter of his current wealth. Put that together with the Twitter purchase, the State of Delaware and Chancellor McCormick have cost Musk about $90 billion, give or take (though a contrary take would involve the words “actions” and “consequences”).
The legal standards
Normally, the decision of what to pay a corporate CEO – like any other business decision – is controlled by the board of directors, and not subject to second-guessing by a court. But, like any other business decision, that changes if the executive pay package can be seen as self-dealing, namely, the decisionmakers have a financial interest in the arrangement.
In a normal company, that isn’t a problem; the corporate directors act at arm’s length from the CEO for the purposes of negotiating the pay package.
In companies with controlling shareholders – like Meta and Mark Zuckerberg, for example, which McCormick namechecks in her opinion – any compensation package would necessarily be tainted with the specter of self-dealing (how seriously can the Meta board bargain against Zuckerberg?), and so controllers tend to forego compensation entirely, which, of course, seems reasonable because they already have so much equity in the company that they are plenty incentivized to come to work every day.
That said, if a company chooses to engage in a conflicted transaction, it is not automatically illegal; it simply is assessed under a complex set of legal standards if it is later challenged in court by a stockholder.
The basic rule is, if an independent decisionmaker interposes themselves in the process, the court will defer to that decisionmaker. If not, the court will closely examine the transaction to ensure its fairness.
Typically, the independent decisionmaker will be independent board members. In the process of negotiating an executive pay package, for example, some board members may have close ties to the executive, but others will not, and so the ones who can be objective will make the call.
Alternatively, the independent decisionmaker can be the disinterested shareholders, who can vote to approve the transaction.
In Delaware, however, those rules only hold for conflicted transactions that do not involve a “controlling shareholder,” or controller. Typically, controllers are those who control more than 50% of the company’s voting power, but control may in fact exist through other means. More on that in a minute.
Delaware courts have come to coalesce around the rule that if a controlling shareholder is on the other side of a conflicted transaction, both board members and disinterested stockholders may be so intimidated or captured by the controller that they will be hesitant to buck his will. Hence, those transactions can only be cleansed if both the independent directors, and the disinterested stockholders, approve it.
If only one mechanism is used – just independent directors, or just disinterested stockholders – controlling shareholder conflict transactions will still be assessed for their fairness, but the stockholder plaintiff will have the burden of proving by a preponderance of evidence a lack of fairness, rather than the defendant controller proving fairness.
What McCormick found
Formally, in Tornetta, the court concluded that Elon Musk was a controlling shareholder of Tesla, at least for the purposes of setting his compensation package. The court considered both his 21% percent stake, and his “ability to exercise outsized influence in the board room” due to his close personal ties to the directors and his “superstar CEO” status. She recounted the process by which the pay package was set, noting in particular that Musk proposed it, Musk controlled the timelines of the board’s deliberation, and he received almost no pushback – board members and Tesla’s general counsel seemed to view themselves as participating in a cooperative process to set Musk’s pay, rather than an adversarial one.
What about the stockholder vote? That, too, was tainted, because – McCormick concluded – the proxy statement delivered to shareholders contained material misrepresentations and omissions. It described Tesla’s compensation committee as independent when in fact the members had close personal ties to Musk, and it did not accurately describe the manner in which his pay package was set – again, with Musk himself proposing it and the board largely acquiescing. With those findings in hand, McCormick did not rule on the plaintiff’s additional arguments that the proxy statement was misleading for other reasons (namely, it falsely described the payment milestones as “stretches” when in fact the early ones were already expected within Tesla internally.)
Therefore, McCormick turned to the fairness analysis, with defendants bearing the burden of proof. McCormick recognized that Musk had delivered extraordinary value for Tesla, but that was only one side of the equation. The other side was whether his shockingly large pay package was necessary to get that result; given that Musk already held a 21% stake and had no intention of leaving the company, she concluded it was not. Or, at the very least, the package was flawed because the Board had not even asked whether such sums were necessary. Moreover, in its deliberations, the Board had identified precisely one particular concern about Musk: Whether he was too distracted by his outside interests to focus on Tesla. But there was no further discussion of that issue, and no proposal to condition his pay on limiting his distractions.
McCormick did not specifically so hold, but she must have been aware that, far from incentivizing Musk’s undivided attention, the Tesla pay package enabled Musk’s purchase of another massive distraction that almost certainly is damaging Tesla’s brand.
And, well. Here we are.
Currently, however, Delaware is in the process of reevaluating its standards for reviewing controlling shareholder transactions. The argument under consideration is whether certain kinds of transactions – executive pay packages, for example – can be cleansed, and thus insulated from judicial review, through one protective mechanism rather than two (independent board or independent shareholder approval), the same way conflict transactions that do not involve a controlling shareholder usually are. Even if the Delaware Supreme Court so holds, though, that fact alone would not necessarily save Musk’s pay package, because McCormick concluded Musk’s pay package was not cleansed either way. She might have to rejigger her findings a little to clarify, but that’s all.
Similarly, if the Delaware Supreme Court were to conclude that Musk did not, in fact, deserve the formal label of controlling shareholder – say it suddenly set a bright line rule that controlling shareholders must have 50% of the vote – that still would not save Musk’s pay package (though, again, McCormick might have to revise her opinion a little), because McCormick made clear that the board’s decisionmaking was tainted by close ties to Musk no matter what label you apply (see fn. 546: “The factual findings that render Musk a controller, however, support a finding that the majority of the Board lacked independence.”), and so was the stockholder vote, so either way, there was no independent decisionmaker.
If, however, the Delaware Supreme Court did two things – say it both concluded that Musk was not a controlling shareholder, and it overturned McCormick’s factual finding that the shareholder vote was tainted – that might save Musk’s $51 billion, though – again, more below – the more likely outcome is McCormick would have to retry certain aspects of the case.
The overriding sense that one gets from this opinion that the bill for Tesla’s open and notoriously poor governance standards just came due.
Tesla shareholders, as well as other commenters, have for years complained about everything from the close personal ties Tesla’s board has to Musk, to the manner in which Musk’s other companies compete for his attention, to Musk’s open defiance of his settlement with the SEC, to the fact that Musk casually conscripts Tesla employees to work at other companies in his empire. Now, for the first time, all of these aspects of Musk’s reign coalesced into a single, legal conclusion that was fairly obvious to the rest of us but I think has devastating implications for Tesla going forward: Tesla’s board exercises no oversight over Elon Musk.
McCormick even took on the “Technoking” title:
Musk testified that the title was intended as a joke, but that is a problem in itself. Organizational structures, including titles, promote accountability by clarifying responsibilities. They are not a joke.
McCormick was obviously ruling in the shadow of VC Slights’s previous conclusion that Musk had not exercised control over the board for the purposes of the SolarCity acquisition, and so formally, she limited her own holding to Musk’s control for the purposes of his pay package, but she also drew in the entirety of Musk’s tenure. And, in a footnote, she pointed out that though Slights had characterized board member Robyn Denholm as a “powerful, positive force,” that particular version of Denholm had not shown up in McCormick’s courtroom:
this court previously held that Denholm was “an independent, powerful and positive force during the deal process” that led to the SolarCity acquisition. And that was surely true at the time. But it was not a factual finding that carries forward for all time. Moreover, Denholm’s approach to enforcement of the SEC Settlement, including unawareness of one of its key requirements, suggests a new lackadaisical approach to her oversight obligations.
Leaving aside the legal formalities, the obvious question is – was McCormick right? Whether or not Tesla formally complies with Delaware corporate governance standards, Musk has unquestionably delivered extraordinary value to its shareholders. The “Technoking” title may very well highlight the casualness with which Tesla directors approach their responsibilities, but also that’s the kind of thing Tesla shareholders value. It may not improve cash flows, but, at least historically, it improves stock prices by pleasing Musk fans. Which raises a very interesting doctrinal question – one I think posed in a more academic way in this paper by Charles Korsmo and Minor Myers – is it the duty of a Delaware board to raise stock prices – even by, say, taking Zoom calls with no pants on or buying a gold mine – or is it the duty to improve fundamental value?
Societally we may prefer the latter but Tesla shareholders individually presumably prefer the former. On the other hand, even the share-price approach is a bit like catching the tiger by the tail; it only lasts as long as Musk’s star power lasts, and that may not be forever.
I was struck by Antonio Gracias’s testimony that the package was designed to give Musk “dopamine hits,” because I think that is not a bad way to look at it. Yes, he presumably was internally motivated to boost Tesla’s stock price because of his own 21% stake, but we all know – or we think we know – Musk’s psychology. What motivates him psychologically isn’t (just) the money, but things he views as outrageous challenges. Maybe by gameifying his compensation package – presenting him with impossible goals and then, when he met them, ringing bells and showering confetti and gold coins – the board really did extract maximum performance.
On the other hand, as McCormick repeatedly emphasized, there was some evidence that at least the early goals were not particularly challenging. But that’s just like any game; the first levels are always the easiest.
We could also ask whether McCormick reached the right conclusion about the shareholder vote. Yes, the proxy statement may not have explained the full extent of Musk’s board ties, but did anyone really not understand the Tesla board’s (lack of) independence? (An internal document from ISS made pretty clear that ISS, at least, believed the board to be weak, but for whatever reason was hesitant to say so openly). And once you know all that, did it really matter that the full embarrassing process by which the compensation package was formulated was not laid out in the proxy? Surely no one thought this was an arm’s length negotiation?
The problem, from my perspective, is that those gut level reactions do not map to the legal standards in a coherent way (you can use concepts like “materiality” or whatnot but there is no way to apply those in the kind of “one ticket only” way that Musk and Tesla require). And of course, the legal standards have a societal function of professionalizing large, powerful companies, in a way that is important even to nonstockholders, regardless of their specific impact at Tesla, though that’s not something Delaware can formally acknowledge.
What happens now?
Now, I assume, Tesla appeals. I am not going to hazard a guess on outcome, though I will make a couple of quick observations.
First, as I have previously written – twice – Delaware’s standards for determining who gets the label of “controlling shareholder” are very malleable. However, as I blogged previously, I think in its SolarCity opinion, the Delaware Supreme Court did provide some guidance on that score, suggesting, in a roundabout way, that only the power to elect directors and approve transactions, or possibly block them, should factor in to the analysis. McCormick did not take that hint, though; she did a more holistic review, which may turn out to be legally vulnerable. But, as I said above, that’s not enough, standing alone, to knock out her core conclusions.
Another area that might be the focus of an appeal would be the shareholder vote. Musk could argue that the omissions were, in fact, immaterial to shareholders. I will not say that is a losing argument, but I will say it would be aggressive if the Delaware Supreme Court were to reverse on that score. If it did so, however, that – standing alone – would not save Musk’s pay package. So long as Musk retains the “controlling shareholder” label – and Delaware maintains its double-protection rule for controlling shareholder transactions – a reversal on that score would mean, at most, a remand to shift the burden of proof from defendants to the plaintiff, and I think it’s … unlikely … the outcome would change. Plus, McCormick did not even rule on arguments that the proxy statement was misleading for other reasons, so a remand would give her another crack at that issue.
And if Delaware both changes its standards for cleansing controlling shareholder transactions (or holds Musk was not one), and holds the shareholder vote was not tainted, that still should result in a remand for McCormick to determine whether the plaintiff’s additional arguments that the proxy statement was false – the ones she did not engage – succeed. For Musk to get a complete win, in other words, the Delaware Supreme Court would likely have to conclude either that he is not a controller (or that controller-conflicted transactions do not need two levels of protection), and that the shareholder vote was not tainted, and that the claims McCormick did not rule upon have no merit and do not need to be tried.
That is … a tough lift for Musk.
Notice I have not even considered the possibility the Delaware Supreme Court would reverse McCormick’s findings that the board was beholden to Musk because … no. I mean, Musk could argue that there is nothing bad about a board “cooperating” with a CEO to develop a pay package; he could try to make a parody of McCormick’s findings by claiming that she unfairly seemed to want the CEO and the board to be at loggerheads, but … no.
Which means on the law, I like the plaintiff’s chances. On the political economy, though – well, Musk is obviously beating some very loud drums about reincorporating out of Delaware, and I have previously asked whether that kind of thing could influence Delaware’s decisionmaking. On the other hand, the Delaware Supreme Court cannot be seen as capitulating to Musk, which means if it reverses McCormick, it must have a fairly solid basis to do so.
Edit: I suppose the Delaware Supreme Court could reweigh the evidence and conclude the pay package was fair, but that would be extremely aggressive. So aggressive that it literally did not occur to me, which is why I had to edit this post.
Edited again (Feb. 3): The “fairness” inquiry that Delaware courts conduct consists of two aspects: the fairness of the process, and the fairness of the ultimate price. I went back to the Delaware Supreme Court’s SolarCity opinion, and there, the court was very clear that ultimate question of whether a price was fair (one half of the overall fairness inquiry) is a legal question that rests upon factual conclusions. As the Delaware Supreme Court put it reviewing the Chancery court’s findings, “We conclude that the record supports the Court of Chancery’s legal conclusion that the price paid was a fair one and that the trial court did not misapply the entire fairness standard.” That matters because the Delaware Supreme Court will defer to Chancellor McCormick’s factual findings, but does not defer to her legal ones. So that’s probably one of Musk’s best lines of argument: even if you accept all of Chancellor McCormick’s factual findings about the flaws in the process by which his compensation package was set, the Delaware Supreme Court has the authority to consider anew whether, in light of the huge value Musk was required to deliver to shareholders, the grant was unfair.
As for the board’s failure to curb Musk’s outside ventures, the response is obvious: it chose to directly compensate him for performance, rather than the methods he used to achieve that performance. I.e., promise him the moon if he substantively delivers, and let him decide what efforts will be required.
That said, the first tripwire I see for him is McCormick’s conclusion that the early milestones were easy ones.
No, but what happens now to Tesla?
Let’s assume the opinion stands. That company does not have a lot of great choices.
Assuming Musk does not want to go the Zuckerberg-no-compensation route, any new compensation award will have to be negotiated by the board in the shadow of McCormick’s findings (not to mention Musk’s threat to breach his fiduciary duties by diverting AI opportunities from Tesla to his other companies, which, this post is long enough, I am not going there).
But the problem extends beyond compensation to a host of other issues. There are already pending cases, that have been stayed, about board oversight of Musk – the failure to monitor his tweets, for example, or to enforce the SEC settlement – at this point, I’ve lost track of them all. Tesla was just accused of dumping hazardous waste; that’s the stirring of a Caremark claim. Musk has been using Tesla engineers at Twitter – there’s a claim for self-dealing. Each new Musk antic will prompt another lawsuit, and every single time, the plaintiff will begin by citing the Tornetta decision as evidence that the board is not independent of Musk and cannot consider a demand. It’s like a dam has broken, a wall of protection around Musk – the polite fiction, which no one believed to begin with, that he operates under board oversight.
One way out would be to visibly and strongly restructure the board – possibly by appointing new members. But can anyone imagine Musk tolerating a genuinely empowered board that tried to, among other things, curb his outside ventures?
Another way out would be for Tesla to follow through on Musk’s latest suggestion: Reincorporation to Texas. That would require a shareholder vote, but Tesla’s stock is, like, 40-50% retail, with another chunk held by Musk and Musk allies, it’s not literally impossible that the vote would succeed.
But can you even imagine what the lawsuit would look like if Musk’s board proposed reincorporation to Texas on the basis of Musk’s Twitter poll, after a shocking indictment of its stewardship?
There is currently pending a lawsuit challenging a Delaware reincorporation to Nevada. It’s a novel claim that the controlling shareholder is seeking to avoid Delaware’s strict standards for reviewing conflicted transactions. I have no idea how that will come out; it’s a dilemma for the Delaware courts.
But in Tesla’s case – and someone correct me if I’m wrong – it’s not quite as obvious that the formal legal standards in Texas are so different from Delaware’s. They seem pretty MBCA-like: universal demand, there may be some limits on what counts as interested/dependence/independence but nothing a clever plaintiff couldn’t plead around. That’s not the reason Musk wants to go there; he wants to go there because he expects the judges will be biased in his favor.
Suing shareholders would argue that the reincorporation was intended to protect Musk’s ego and his power, not shareholder value. Which brings us back to the question posed by Tornetta: Is shareholder value measured by stock prices alone?
As for me, here’s to another round of edits to my Twitter v. Musk paper, now forthcoming in the Virginia Law & Business Review.