Thursday, April 18, 2024

Tesla and Waste

Yup, we have another opportunity for Elon Musk to make new law.

This time, it comes in the form of an extraordinary proxy statement recommending that shareholders vote to ratify the compensation package that Chancellor McCormick invalidated in Tornetta v. Musk, and that they vote to reincorporate the company in Texas.

There are many many questions raised and I’m sure I’ll be revisiting a bunch of them over the next couple of months, but I’m zeroing in on one in particular: the pay package ratification vote.  Can they really do that?

And hoo boy did this get long, so behind a cut it goes; however, I personally find the most interesting part to be the realpolitik of it all if it ends up in a courtroom, so knowledgeable readers may want to skip to that part at the end.

More under the jump

Let’s leave aside the obvious issues of the independence of the special committee of one, namely, Kathleen Wilson-Thompson, the suggestion that only a captured board would even make these proposals, whether the proxy statement is complete and accurate, all of which I am sure will be the subject of future controversy.  Let’s assume it all is what it is at face value.  Then the question becomes, can a majority shareholder vote restore the 2018 package?

Tesla argues initially that this would be a ratification of a defective corporate act under DGCL 204.  If we accept that under Delaware law, board actions are “twice tested” – first for statutory authorization, and second for compliance with fiduciary obligations – then DGCL 204 would seem to be designed to handle problems with the former, not the latter, and is inapplicable here.

So that brings us to the common law issue.  Can a board choose to award the pay package for past work, subject to shareholder ratification upon disclosure of the complete facts?

Certainly, a board could award backpay in order to ensure Musk’s future services.  That is, if Elon Musk were to say, I refuse to serve as Tesla CEO unless you restore my old pay package (presumably, in addition to granting a new one), that would be a legitimate reason for the board to restore the old award.

The problem is, Musk isn’t saying that.  Nothing in the proxy suggests he’s said anything like that, and of course, in her Tornetta decision, Chancellor McCormick found that Musk never had any intention of stepping away from Tesla.

So now we have a narrower question: Can the board choose to grant a pay package of that size simply as a reward for past work, that has already been accomplished and can’t be taken back?

For sure, boards award bonuses and rewards to people for their past work all the time, even when not contractually obligated to do so.  In fact, there’s a line of Delaware cases approving retroactive awards for “extraordinary” past work if amounts involved are not “unreasonable,” Blish v. Thompson Automatic Arms Corporation, 64 A.2d 581 (Del. 1948), or upon an executive’s retirement, Zucker v. Andreessen, 2012 WL 2366448 (Del.Ch. June 21, 2012).

But – though I suppose you could make the argument – it’s very difficult to say those cases would apply here, because those situations, too, have forward-looking elements: continuing employees may be motived to perform well in the future, retiring employees offer consideration to the company (assistance with succession planning, extension of confidentiality agreements, see Zucker, 2012 WL 2366448 at *8), and of course, in general, other employees can see the awards and may be motivated to offer similar service in hopes of receiving their own. 

None of that is relevant here.  Tesla is not arguing the award is necessary to secure Musk’s future services and it’s not like there are comparable Tesla employees out there looking to Musk’s compensation as a model for themselves.  Plus, McCormick already concluded that the amount was unreasonable

Making the problem even more difficult, Tesla itself does not offer much of an economic justification for restoring the old pay package.  The only reasons being offered for restoring the package are:

Stockholders Want To Speak For Themselves….

A Ratification Vote Cures Tornetta’s Disclosure Criticisms. ….

Ratification Could Avoid Further Uncertainty Regarding Musk’s Compensation And Motivation…..

Seeking Ratification Now Potentially Avoids A Criticism Of The Reincorporation Vote.

Seeking Ratification Now Potentially Avoids Other Costs….  

Let’s take these justifications one by one.

“Shareholder democracy” sounds great on a poster but anyone will tell you, a Delaware corporation “is not a New England town meeting.”

Disclosure is all fine and good but it’s not by itself an economic justification for the award. 

The claim that ratification will eliminate uncertainty is undercut by the accompanying footnote: “Of course, even a favorable ratification vote by stockholders may not fully resolve this matter. The Committee and its advisors cannot predict with certainty how a vote to ratify Musk’s compensation would be treated under Delaware law in these novel circumstances.”  Seems to me, it’s only going to inspire additional litigation.

I actually agree, seeking ratification under Delaware law avoids the suggestion that reincorporation is being sought just to give Musk his pay package back, but it’s not a primary justification in the first instance.

Which brings us to the final rationale: avoiding other costs.  What costs are those?

For one, the report mentions the lawyers’ fees in the original Tornetta action.  I won’t weigh in on the legal effect that ratification would have on those fees, but I can count, and Musk’s comp package costs a lot more than paying the fees, if you’re doing a trade.

Another cost avoided is the time to negotiate a replacement compensation package “in order to motivate him to devote his time and energy to Tesla,” coupled with something about the tax effects of a new package.  And the proxy states, cryptically, “the Special Committee did not seek to negotiate a new compensation package with Mr. Musk and there is no such new compensation package planned by the Company.”

The problem is, don’t we expect they’re going to consider a new package on a go forward basis at some point?  Before Tornetta came down, Musk tweeted that very thing: that the board was waiting for Tornetta before negotiating a new deal.  He demanded 25% of the company so he could develop AI, there were headlines about it.  Are they seriously suggesting that if Musk gets his back pay, there won’t be any future comp packages?  

Hey, that might be something the SEC could ask about.

But more generally, let’s say – fine.  The point is this is an award intended for the future, to motivate him.

Then we have another problem, which is Wilson-Thompson did not evaluate the fairness of the package to ensure Musk’s future motivation, nor did she hire a compensation consultant or financial advisors to assist with that endeavor.  According to the proxy statement, “the Special Committee did not substantively re-evaluate the amount or terms of the 2018 CEO Performance Award and did not engage a compensation consultant. It did not negotiate with Mr. Musk.”

Instead, check out this language from Wilson-Thompson’s report:

The Committee did not renegotiate the amount or terms of Musk’s 2018 compensation plan. That would not have been, in the Committee’s view, ratification; that would have functionally been a new compensation process and a new compensation plan, to be judged on their own substantive merits. The Committee also did not evaluate whether the amount or terms of Musk’s 2018 compensation plan were fair, or opine on the Tornetta ruling about its fairness. The Board previously decided in January 2018 that the compensation plan was fair, and Wilson-Thompson was not on the Board at that time. Moreover, the defendants will be appealing the Tornetta ruling because they believe the compensation plan is fair and should be upheld as agreed. The Committee assessed only whether this 2018 compensation plan, as it was previously agreed to, should be ratified at this time, based on the facts that currently exist.

(emphasis in original)

Tesla seems to be trying to have it two ways: this is both a new compensation package, with new board consideration and new shareholder approval, in light of facts that exist today, and an old one.  By saying it’s an old one, Tesla can claim there was no need to reconsider the substance of it; by saying it’s a new one, Tesla can claim that the process was done correctly, with an independent board committee and full disclosure to shareholders.

Legally, there’s a reason for the slipperiness.  McCormick found that Musk was a controlling shareholder when he negotiated the original grant, and under Kahn v. M & F Worldwide Corp, 88 A.3d 635 (Del. 2014), controlling shareholder transactions must be negotiated by an independent committee, and conditioned on disinterested shareholder approval, from the outset.  There’s no path to offer those protections midway through negotiations, because of the risk that the protections themselves will be traded for concessions to the controller.  Or, more simply, the tainted original negotiations may improperly serve as an anchor once the protections are in place – and I can’t think of anything more anchoring than Wilson-Thompson explicitly refusing to reconsider the substantive merits of the original grant. 

So.  If this is all part of the original transaction, it violates MFW.  But if it’s an entirely new grant, we need a reason for it – and we’re back to the part where the only economic reason is future motivation, which was not actually considered by Wilson-Thompson in any kind of rigorous way. 

Wilson-Thompson’s report refers to “fairness.”  Fairness is something to strive for, but the reason that McCormick found the package was unfair was because the shareholder vote was tainted by misleading disclosures, and the board was captured by Musk, who manipulated their deliberative process, resulting in a compensation award that was far beyond what was needed to secure his services, given that, as a large Tesla shareholder, he already had plenty of motivation to increase Tesla’s value.  Moreover, she also found the compensation package was short-termist in its goals and, well, looking at Tesla’s stock price as of this posting, it’s hard not to agree.

Plus, we all know what Musk does with extraordinary excess wealth: he uses it to pursue outside projects, like Twitter, which only draw his attention away from Tesla, rather than toward it.

More generally, Delaware corporations are supposed to maximize shareholder wealth; fairness, like any other virtue, is only to be pursued instrumentally, in service of that end.  Cf., Verition Partners v. Aruba (“Orr pursued the HP deal … because of loyalties to constituencies beyond the stockholders. In the grander scheme of life, I find that commendable. For the narrow purpose of Delaware corporate law, those competing loyalties are factors that a court has to weigh.”); eBay Domestic Holdings v. Newmark, (“I personally appreciate and admire Jim’s and Craig’s desire to be of service to communities.  The corporate form in which craigslist operates, however, is not an appropriate vehicle for purely philanthropic ends, at least not when there are other stockholders interested in realizing a return on their investment.”).

Usually, behaving “fairly” will motivate employees and other constituencies to perform well in the future, but, in this case, once again, that’s off the table.

Which means, awarding back pay in this instance looks like – a gift.  A sheer gift to Musk out of gratitude for his past work for Tesla.

Gifts are nice.  Gifts are fine.  But a gift of corporate assets with no corresponding benefit falls into the legal category of “waste.”  In fact, the classic “waste” cases – there are very few, it doesn’t happen often – were sort of like this fact pattern, i.e., a board decides to award a large pay package to a founder/insider, with no plausible benefit to the firm.  

Technically, waste is a kind of ultra vires act undertaken by the board that can only be ratified by a unanimous shareholder vote, rather than simply a majority vote.  See Harbor Financial Partners v. Huizenga, 751 A.2d 879 (Del. Ch. 1999). 

To be sure, as Steve Bainbridge pointed out on exTwitter, that standard fits somewhat uncomfortably alongside more modern approaches to Delaware law, because – as VC Laster has written – today, waste is viewed less as ultra vires than as a kind of bad faith fiduciary breach.  And fiduciary breaches, usually, can be cured with a simple majority vote of the disinterested shareholders.  So there’s certainly an argument that the old unanimity standard should be rejected in favor of the modern rule.

That may be a tough lift, though.  Does that mean other kinds of bad faith acts can be ratified by shareholders?  What if the board violates Caremark by failing to adopt a surveillance system to identify legal violations; can that be cured by a majority shareholder vote?

More generally, by hypothesis, we’re assuming a transaction that leeches wealth from the firm with no plausible corresponding economic benefit.  The shareholder vote is itself predicated on the notion – legally – that shareholders are acting to pursue their economic interests.  And in a world where boards are legally obligated only to pursue wealth maximization, there’s something to be said for a rule that shareholders cannot ratify board action that is, again, by hypothesis, economically irrational and wealth-decreasing. 

That said, consider what happens if/when this ends up in court.  If shareholders vote to reject the pay package, then we’re done.  So while there might be all kinds of skirmishes over board independence and proxy disclosures and what not, we’ll only get to “pure” arguments about the limits on economically irrational action in the event that the shareholders have voted in favor.  

Tesla has a large retail shareholder base, but if the resolution passes, almost certainly some large institutions will have supported it.  The proxy statement mentions certain unnamed large institutions have already indicated their support, and includes a letter from T. Rowe Price, arguing that it would only be “fair” to award Musk his backpay.

It may be difficult, as a factual matter, to argue that the pay package is economically irrational if large institutional shareholders vote in favor of it.  After all, are we claiming that giants like BlackRock and T. Rowe Price are voting to give away corporate assets?

don’t find that plausible but Tennessee and Mississippi do; they’re suing BlackRock alleging exactly that, namely, that it is pursuing a climate change agenda to achieve its own environmental goals rather than to maximize wealth for investors.  And any number of academic luminaries have written extensively about the conflicts faced by large asset managers, and have proposed that their influence be reduced in various ways.

I also keep thinking about the bind these funds are in.  There is something gut-level appealing about “deal’s a deal” logic, and that’s the argument in T. Rowe Price’s letter.  I could even imagine something vaguely wealth-maximizing about demonstrating that a corporation lives up to its commitments, which would put us back to economic justifications for ratifying the package.  But then we’re also back to grappling with – as the letter does not – the factual findings by McCormick that Musk manipulated the deal to his advantage and Tesla misled shareholders about it in the proxy.  If T. Rowe Price or any other institutional investor thinks Musk should get backpay in a “deal’s a deal” way, my question is, what do they think of McCormick’s factual conclusions?  Do they disagree that they were misled?  Do they think the process problems don’t matter?  I’m not saying either of those things is off the table, actually, but I am saying a clearer articulation would be helpful.

And then there’s the elephant in the room.  If large asset managers vote to restore the grant – which is still shockingly rich, even though Tesla’s stock price has tumbled well below the original milestones – the suspicion will be that they’re doing it not to motivate Musk to perform well or to reward him for past performance, but to keep Musk from further sabotaging the company, by, say, tweeting “Tesla stock price too high” or pursuing AI in his outside ventures while using Tesla data

One of the more interesting details to come out of the Tornetta litigation was that ISS, apparently, pulled its punches in its recommendation on the original package, hesitating to openly accuse the Tesla board of a lack of independence.  Coerced votes – under threat that the company will be torpedoed if shareholders don’t approve a particular course of action – do not have a ratifying effect under Delaware law

But, of course, proving coercion would be difficult here; we might suspect it, but certainly nothing in the proxy statement hints at it.  Let’s just say discovery into large shareholders’ true motives would be. Entertaining, if we ever got that far.

So, there is a real case for waste here, and, at least until the law changes, waste can only be ratified unanimously.  Still, the easiest practical strategy for a court might simply be to say, it’s implausible to think that large asset managers would vote for something economically irrational, therefore it’s not economically irrational, therefore it’s not waste, and therefore a unanimous vote is not necessary.  I don’t find that especially satisfying, but it’s certainly the path of least resistance, if that’s where we end up.

I’ll finish with this:  I kind of assume we’ll see an enormous amount of political pressure on the large asset managers to vote this way or that way, to demonstrate their support/lack thereof of Elon Musk personally.  (Same for the recommendations of the proxy advisors.)  Which is, you know, how we do corporate governance now, but also is yet another example of the conflicts institutional shareholders might face.

Ann Lipton | Permalink


I'd argue with your saying there is no forward-looking aspect to paying Musk for past services. Fairness matters for a company's reputation. Even if a company can legally avoid honoring agreements, it would like to have a reputation for honoring them. Otherwise it is too risky for anyone to contract with it. No contractor is exactly in Musk's position, but Teslas has a vast number of contracts. Workers would feel safer if they knew Tesla is a fair company, that would pay out their pensions even if a clever lawyer figured out a way to void them all. Suppliers, same thing. And remember that the business judgement rule is behind all this.

Posted by: Eric Rasmusen | Apr 18, 2024 9:11:13 AM

Thanks Eric. I do consider that when I talk about T. Rowe Price. The difficulty is invoking fairness w/o explaining why the original Tornetta findings don't undermine fairness.

Posted by: Ann Lipton | Apr 18, 2024 9:13:45 AM

I happen to know the head of the compensation committee (discussed quite often in the Deleware case) had to find an independent compensation consultant who would approve the comp plan as one or two said they would not support the plan. Great analysis Ann

Posted by: Jim Braken | Apr 21, 2024 5:07:33 AM

To need to preserve a reputation for honoring contracts, you have to have a reputation for honoring contracts. Tesla already has a reputation for breaching contracts:

... as does, of course, Musk, see ...

and ...

and, of course, ...

Posted by: John C Coates | Apr 26, 2024 3:56:03 PM

Hah, John, speaking of that - during the "private at 420" trial, Musk testified that he was sure the Saudis would come through and fund a buyout bc a deal's a deal, and Musk himself always expects contracts to be honored. It was only months after he had been forced to buy Twitter, it was amazing to behold.

Posted by: Ann Lipton | Apr 26, 2024 3:59:53 PM

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