Entire Fairness Review of Tesla CEO Compensation

Robert A. ProfusekLizanne Thomas, and James P. Dougherty are partners at Jones Day. This post is based on a Jones Day memorandum by Ms. Thomas, Mr. Profusek, Mr. Dougherty, Randi C. Lesnick, and Jennifer C, Lewis. This post is based on their Jones Day memorandum and is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here), The Growth of Executive Pay by Lucian Bebchuk and Yaniv Grinstein, and Independent Directors and Controlling Shareholders by Lucian Bebchuk and Assaf Hamdani (discussed on the Forum here).

A Tesla shareholder challenged a unique and extremely lucrative equity grant to Elon Musk, claiming that the directors’ decision to approve the pay package breached their fiduciary duties. The compensation consisted of stock options that only vested upon Tesla’s achievement of extraordinary market cap and operational milestones, with a value to Musk of up to a staggering $55.8 billion.

The performance award was approved by Tesla’s independent compensation committee and its full board of directors, with Musk and his brother recusing themselves. The award, which was also conditioned on the approval of a majority of the disinterested shares, was approved by 73% of the disinterested shares voted, or 47% of the outstanding disinterested shares.

The Chancery Court acknowledged that although the ratifying shareholder vote would justify business judgment review in ordinary circumstances, it was insufficient in the case of compensation granted to a controlling shareholder, even in the situation, such as this one, where the shareholder vote is made on a fully informed basis. Accordingly, the Chancery Court denied the directors’ motion to dismiss, holding that the exacting “entire fairness” standard of review was warranted in the circumstances, in part because fewer than a majority of the disinterested shareholders voted to ratify the award.

The Chancery Court’s decision will have limited impact on executive pay cases, as few CEOs of public companies are controlling shareholders. When considered with other recent decisions focused on compensation issues, however, the Tesla decision demonstrates the Chancery Court’s willingness to permit compensation cases to proceed past initial dispositive motions and onward through discovery and to trial under the most stringent standard of judicial review. Quite possibly, the Court’s refusal to grant dispositive motions at the outset of these cases is due at least in part to a sentiment that executive compensation levels are simply too high—and that the peer comparisons used to justify C-suite pay levels ultimately tend to support ever-increasing pay levels for many public company executives.

Compensation cases are being reviewed in a time when the topic of income disparity has become a major and divisive political issue, as seems to happen whenever a significant shift in the basic economic model occurs. However one may feel about this as a political or social issue, the legal standards for compensation have long been established—absent corporate waste, a standard so difficult to meet it is almost never even pleaded; process, not amount, counts, and the business judgment rule applies to a compensation decision made by independent directors even if it involves what seems to be a lot of money. As the Delaware Chancery Court held in the Disney compensation decision: Nature does not sink a ship merely because of its size, and neither do courts overrule a board’s decision to approve and later honor a compensation package, merely because of its size.

Moreover, under the system that Delaware has implemented, shareholders dissatisfied by board decisions should generally challenge those decisions at the ballot box. In the current environment, votes against say-on-pay proposals and director elections have increasing meaning—and consequences—for public company boards. From a legal perspective, however, if the appropriate procedures are followed, shareholders must live with the outcome of director decision-making, even if it’s not a result they like. As said in Disney, the legal rules that govern corporate boards are resilient—irrespective of context.

Until the Delaware courts return to basic principles, companies should expect continuing compensation challenges and litigation. A key element of this defense includes a careful and painstaking review of the proxy statement disclosure concerning the company’s compensation philosophy, policies, and practices. Companies must flyspeck their compensation disclosures to ensure that all relevant information about director and executive pay—and the processes by which they are approved—are disclosed fully and accurately. It has become too easy for plaintiffs’ disclosure cases to survive a motion to dismiss, and Compensation Discussion & Analysis (“CD&A”) disclosures are a likely next target for the plaintiffs’ bar. Accordingly, companies should be prepared to defend each line of their CD&A disclosures as thoroughly as they would their IPO prospectuses. The plaintiffs’ bar is deliberate, thorough, and highly motivated—and companies must be, as well.

Two Key Takeaways

  1. The Delaware Chancery Court is demonstrating an increasing willingness to hold board decisions relating to directors and officers compensation to the most stringent level of judicial review.
  2. Companies and their boards should take caution to use their own stringent review on their disclosures about compensation matters, particularly in the corporate proxy materials.

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