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 The court rescinded the incentive package mainly because Musk was found to control Tesla and the process, the directors authorizing the package were not independent and the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