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Process still matters.  That’s the main takeaway from the Delaware Court of Chancery’s 200-page opinion striking down Tesla’s 2018 incentive package awarded to Elon Musk.  The court rescinded the incentive package mainly because Musk was found to control Tesla and the process, the directors authorizing the package were not independent and the stockholder vote approving it was not properly informed.  The ruling is a stark reminder of the importance of both director independence and an informed stockholder vote when transacting with a control stockholder.

The 2018 Stock Option Grant

In 2018, the Tesla board approved a new stock option package for Elon Musk and then submitted the proposal for stockholder approval. At a special meeting of stockholders, 81% of the shares voted in favor (or 73% without counting Musk’s and his brother’s shares). If exercised in full, the option package would have allowed Musk to purchase a number of shares constituting 12% of Tesla’s outstanding stock, subject to both milestone and leadership-based vesting.  The options vested in 12 tranches, with each tranche vesting on Tesla achieving one capitalization milestone and one operational milestone, and only if Musk continued serving as either CEO or both executive chairman and chief product officer at each vesting juncture.  In the most optimistic case, if Tesla’s capitalization grew from $59 billion at the time of the grant in 2018 to $650 billion by 2028 (the option expiration), all the options would vest and be worth approximately $56 billion.  As things turned out, Tesla’s market cap did hit $650 billion by the end of 2020 and all the options vested in full. 

Was Musk a Controlling Stockholder?

Normally, corporate boards may compensate their executives however lavishly as they wish because Delaware courts will show tremendous deference to board decisions under the business judgment rule and not second guess them.  The exception to the general rule is when the compensation is being paid to a controlling stockholder, in which case the compensation or transaction is evaluated under the stricter entire fairness standard which demands a fair price and fair process.  The threshold issue then is whether Elon Musk was a controlling stockholder at the time of the 2018 grant.

Control can be established either through mathematical voting control or effective operational control.  On the surface, Musk’s 22% ownership stake at the time of the 2018 grant did not constitute mathematical voting control.  But perhaps it did when combined with Tesla’s supermajority vote requirement for any amendment to its bylaws governing stockholder meetings, directors, indemnification rights and the supermajority vote requirement itself.  The court’s main focus, however, was on Musk’s “outsized influence” over Tesla’s business affairs in general and over the compensation package in particular.

As to general control, the court found Musk exerted significant influence over Tesla’s board, and that as founder, CEO and chairman he “occupied the most powerful trifecta of roles”. Musk also frequently exercised managerial authority over all aspects of Tesla, in many cases ignoring the Board’s authority such as when he appointed himself Tesla’s “Technoking”, disclosed in a Form 8-K, without consulting the Board.  The Court was also swayed by Musk’s “Superstar CEO” status, which it said resulted in shifting the balance of power toward himself and away from the board, which was supposed to exercise authority over him.

The court also found Musk exerted transaction-specific control.  He almost unilaterally controlled the timing of the grant. There was no negotiation between Musk and the Board over the size of the grant, and no meaningful negotiation over the other terms.  Neither the compensation committee nor the board engaged in any benchmarking analysis.  Directors testified at the trial that they viewed the process as “cooperation”, not a negotiation.

Musk’s controlling stockholder status meant that the applicable standard of review would be the entire fairness standard.  As a procedural matter, the defendants have the burden of proving fair price and fair process.  But defendants (in this case, Musk, the other directors and Tesla) can shift the burden to the plaintiff if the transaction was approved by either a well-functioning committee of independent directors, or an informed vote of the majority of the minority stockholders.  As a practical matter, burden of proof in these cases is determinative; the party with the burden almost always loses.Continue Reading Out of Control!  What the Elon Musk Compensation Case Reminds Us about Transactions with Controlling Stockholders

Starting January 1, 2024, virtually all private companies will be required to report information about their beneficial owners to the Treasury Department’s Financial Crimes Enforcement Network “FinCEN”) under the Corporate Transparency Act (the “CTA”).  But the CTA presents unique analytical and reporting challenges for startups and venture backed companies because of the special economic and governance rights negotiated with investors in early stage and venture funding rounds.Continue Reading Corporate Transparency Act Risks for Startups and Venture-Backed Companies

The Securities and Exchange Commission recently brought its first two enforcement actions against issuers of non-fungible tokens (NFTs), resulting in cease-and-desist orders, penalties and other remedies, finding that the NFTs were investment contracts and that each of the issuers had engaged in an offering of securities without registration in violation of Section 5 of the Securities Act of 1933.  These enforcement actions create legal ambiguity and risk for NFT developers regarding the marketing, transferability and royalty generating capacity of NFTs.Continue Reading SEC’s First Two NFT Enforcement Actions Cast Shadow of Ambiguity

Judge Analisa Torres’ greatly anticipated Order in the SEC’s lawsuit against Ripple is a split decision.  The Order basically finds that Ripple’s digital token XRP is a security when sold privately to individuals and institutional investors pursuant to purchase agreements, but is not a security when sold on a digital asset exchange where sellers don’t know who’s buying and buyers don’t know who’s selling.[1]  Although the Order should be perceived as at least a partial victory for crypto, it perversely upends a fundamental tenet of the securities laws which is that the laws are designed to protect those who cannot fend for themselves.  Moreover, the finding that digital tokens sold anonymously on digital asset exchanges is not a security also seems to contradict the “fraud on the market” theory of securities liability.Continue Reading Parting the Crypto Sea:  Ripple’s XRP Ruled to be a Security When Sold to Private Investors, But Not When Sold on an Exchange

The anti-child trafficking thriller “Sound of Freedom” just opened in theatres on July 4th.  Based on a true story, it stars Jim Caviezal as former Homeland Security special agent Tim Ballard who quits his job with the agency and embarks on a mission to rescue children from traffickers in Latin America.  Another true story relating to the film is that the cost of marketing it has been funded through an equity crowdfunding campaign under Regulation CF.  What makes it even more interesting is that the investment instrument issued in this crowdfunding offering was not your typical stock, convertible note or SAFE, but rather something called a revenue participation right.Continue Reading Revenue Participation Rights as a Crowdfunding Instrument Alternative

In the world of venture capital, there are certain investor rights that ensure the smooth execution of exit transactions.  The primary such mechanism is the drag-along provision, under which one group of stockholders agrees in advance to sell or vote their shares in a sale of the company approved by another group of stockholders and/or by the board.  Drag-along provisions often include a covenant by the drag-along shareholders not to sue over a drag-along sale, often including waivers of claims for breach of fiduciary duties.  But are fiduciary duties of directors too important to allow them to be waived by stockholders?  A recent Delaware Chancery Court decision puts guard rails on such waivers.Continue Reading Too Big to Waive?  Enforceability of Drag-Along Covenants Not-to-Sue

A major theme of this Blog has always been ongoing legislative, regulatory and market initiatives to reform capital markets by targeting unreasonable or outdated impediments to capital formation to make it easier for early-stage companies to raise capital.  These impediments are not always obvious or direct.  One such indirect impediment has been the venture capital adviser exemption under the Investment Advisors Act of 1940, the eligibility requirements of which disincentivize VC investment in secondary transactions and in other VC funds, thereby unnecessarily hampering liquidity in the innovation ecosystem.  If a new piece of proposed legislation passed by the House Financial Services Committee becomes law, however, this impediment will be eliminated.Continue Reading Proposed Reform of Venture Capital Fund Advisor Exemption Will Boost Startup Investment and Founder Liquidity

The collapse of Silicon Valley Bank will have enormous repercussions for startups and VCs in ways seen and unseen.  As for the unseen, SVB had deep relationships among the various players in the venture ecosystem.  Founders and investors established banking relationships with SVB in part because of the opportunities SVB provided to network within the space.  It will be difficult for other lenders who don’t have these deep relationships to replace SVB in this capacity and fill this valuable role.Continue Reading Bumpy Ride Ahead for Startups After Silicon Valley Bank Crash

A new federal law goes into effect March 29, 2023 that conditionally exempts from broker-dealer registration persons who solely intermediate small, private company M&A deals.  Persons who intermediate larger private company M&A transactions will not be eligible for the new exemption and will need to continue to rely on the SEC’s 2014 no-action letter.  The new Federal legislation also does not preempt the states, so M&A intermediaries will need to continue to be mindful of state registration requirements.Continue Reading Middle Market M&A Brokers Get Relief

Will employment non-competes soon be banned nationally?  Perhaps, if the Federal Trade Commission gets its way.  Last month, the FTC issued a Notice of Proposed Rulemaking (the “NPRM”) that would prohibit just about all employment non-competes. The proposal is now going through a 60-day comment period.  If ultimately adopted in anything close to its current form and survives inevitable legal challenges, the ban will significantly impede the ability of employers to safeguard proprietary information.Continue Reading RIP Non-Competes?