Tesla Case: Questions of Process, Independence

February 19, 2024

Judicial opinions rarely make for good reading. The Delaware Chancery Court decision rescinding Tesla CEO Elon Musk’s $55.6 billion performance-based equity compensation package is an exception.

In a 200-page judgment released after the market close on Jan. 30, Chancellor Kathaleen St. Jude McCormick cited Musk’s “extensive ties” to board directors and described him as the “paradigmatic ‘Superstar CEO,’ who held some of the most influential corporate positions (CEO, Chair, and founder), enjoyed thick ties with the directors tasked with negotiating on behalf of Tesla, and dominated the process that led to board approval of his compensation plan.”

In effect, the Court ruled that Musk’s compensation package was a breach of fiduciary duty by a conflicted board that at trial failed to demonstrate that Musk’s pay was fair.

“The primary consequence of this finding,” wrote McCormick, “is that the defendants bore the burden of proving at trial that the compensation plan was entirely fair. …But the defendants were unable to prove that the stockholder vote was fully informed because the proxy statement inaccurately described key directors as independent and misleadingly omitted details about the process.”

What happens next depends on whether Tesla appeals the Chancery Court decision to the Delaware Supreme Court and prevails. The case raises any number of governance questions for boards, especially those charged with representing stakeholder interests at fast-growth companies led by charismatic founders.

 

What was the basis for the case?

The shareholder plaintiff, Richard J. Tornetta, alleged in the June 5, 2018, complaint that Musk and the Tesla board breached their fiduciary duties by providing false and misleading information to investors in awarding Musk an equity-based compensation package valued at $55.8 million. Tesla moved to dismiss the complaint, conceding that Musk controlled Tesla, and that his performance-based pay package was fair.

 

What was in the compensation package?

The equity-only plan offered Musk the opportunity to secure 12 total tranches of options, each representing 1% of Tesla’s total outstanding shares as of January 31, 2018. Dual-trigger vesting for each tranche required Tesla to achieve one additional market cap milestone and one additional operational milestone. In addition, Tesla’s market cap had to increase $50 billion and achieve either an adjusted EBITDA target or a revenue target in four consecutive fiscal quarters. The package was purely performance based: no salary or bonus in either cash or stock. Musk has not exercised any options under the plan.

 

On what basis did McCormick base her decision to rule in favor of the plaintiff and against Musk and the six named board directors?

In her post-trial decision, McCormick wrote that Musk’s compensation was subject to review not under the business judgment rule but under Delaware “entire fairness” doctrine—the highest review standard in corporate law. That meant the defendants bore the burden of proving the compensation plan was fair, which McCormick wrote they failed to do: “The concept of fairness calls for a holistic analysis that takes into consideration two basic issues: process and price. The process leading to the approval of Musk’s compensation plan was deeply flawed. Musk had extensive ties with the persons tasked with negotiating on Tesla’s behalf,” she wrote. On price, McCormick wrote: “Musk launched a self-driving process, recalibrating the speed and direction along the way as he saw fit. The process arrived at an unfair price.”

 

How does a board ascertain the independence of directors?

Definitions of what constitutes independence for a public company director have been written by the stock exchanges, regulated by the Securities and Exchange Commission, and ruled on by the courts. According to the SEC, an independent director is a person who is not in a material relationship with a company’s management, involved in its day-to-day operations, or is involved in a relationship or a transaction that could interfere with their ability to exercise independent judgment.

Tesla board members testified at the five-day bench trial in November 2022 that their relationships with Musk included business and personal ties such as investments and joint family holidays and vacations. Also significant was director compensation for serving on Tesla’s eight-seat board. “Their most significant, potentially comprising factor is the compensation that each received as a Tesla director” which for one was “life changing” and for another constituted a large part of his personal wealth, according to the decision.

A hearing in the Delaware Court of Chancery that also bears watching involves compensation paid to current and former directors of Tesla. A suit filed against current and former Tesla directors by the Police and Fire Retirement System of the City of Detroit alleged they unjustly rewarded themselves in cash and stock valued at $735 million between 2017 and 2020. As part of a negotiated settlement, the directors agreed to return their compensation and forego any pay for 2021, 2022, and 2023. They also agreed to change the way compensation for board members is determined. All parties agreed to the mediated settlement in June 2023 and now await a final hearing by the Delaware court.

 

What was Musk’s reaction to the court decision?

Musk promised to seek shareholder approval to relocate the world’s largest automaker from Delaware to Texas. In a survey on X, the privately held social media-platform formerly known as Twitter that he bought in 2022, Musk asked his followers: “Should Tesla change its state of incorporation to Texas, home of its physical headquarters?” Some 87 percent of the more than 1.1 million votes said yes.

Of the 470 public companies in the Fortune 500, 328 have made Delaware their corporate home, attracted in part to the state’s historically stable and predictable business court decisions and where trials are heard by judges, not juries. The State of Texas is in the process of establishing a specialized business trial court following passage of legislation in 2023.

 

What’s next?

One justification for Musk’s pay package was to keep him focused on Tesla rather than being diverted by one of his other companies: SpaceX, Neuralink, SolarCity and Tesla Energy, The Boring Co., or xAI. How Tesla’s board deals with a demand by Musk this month for a greater stake in the electric vehicle company. Musk said he needed to own 25 percent of Tesla to avoid takeovers and maintain enough control of the company to develop artificial intelligence technology, according to reporting by the New York Times.

 

Farient’s Takeaways

Boards and their compensation committees need to consistently operate within the bounds of good governance. The decision to rescind Musk’s compensation sheds light on how much pay is too much, the definition of director independence, the process by which boards and controlling shareholders make decisions, and the importance of disclosures. There are lessons for all directors and especially compensation committee members from this historic and unprecedented decision.

  • Ensure that compensation decisions are made by directors who are truly independent. Weigh whether the board’s requirements for director independence are clear and clearly disclosed
  • Align pay with performance and benchmark against peers
  • Understand and disclose company processes, protocols, and timelines for arriving at key decisions, especially when those decisions are material
  • Support decisions on sensitive topics with informed discussions and debate that are documented in meeting minutes
  • Explain the compensation plan in clear, comprehensive terms within the proxy’s Compensation Discussion & Analysis
  • Anticipate legal risks and reactions from proxy advisors to the largest institutional investors to minority shareholders

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