Chancery Finds Tesla Board Breached Fiduciary Duties

In Tornetta v. Musk (Jan. 30, 2024), the Delaware Court of Chancery, in a post-trial decision, ruled that the directors of Tesla, Inc. breached their fiduciary duties when, in 2018, they awarded Elon Musk, Tesla’s CEO and founder, a ten-year performance-based equity compensation plan with an estimated maximum value at one time of $55.8 billion. The court ordered rescission of the entire plan, eliminating all of the compensation Musk had earned under the plan. The court emphasized that Musk’s preexisting 21.9% equity stake in the company in any event had “provided him tens of billions of dollars for his efforts” that had increased the value of the company.

The court found that: (i) Musk controlled Tesla, at least with respect to the compensation plan; (ii) therefore, the compensation plan was a conflicted-controller transaction invoking entire fairness review; (iii) although the plan was made subject to approval of a majority-of-the-minority stockholders, the burden to prove entire fairness remained with the defendants because the disclosure to stockholders was materially flawed, preventing a fully informed vote; and (iv) the defendants did not prove that the compensation plan was fair as to price or process. We anticipate that the decision will be appealed.

Key Points

• The court viewed Tesla’s Compensation Committee as having simply given Musk whatever he wanted. Musk proposed the terms of the compensation plan and the Committee essentially did not change them; the Committee members had significant personal and business ties to Musk; and the Committee did not engage in negotiations with Musk. The Committee members testified that they took a “cooperative and collaborative” approach, thinking about what “felt fair for Musk,” as they believed that he had to be happy with the plan or else the board’s objectives to retain and incentivize him would not be achievable. The court emphasized that a CEO compensation plan process is inherently adversarial and must involve arm’s-length negotiation with the CEO, rather than “work[ing] alongside him, almost as an advisory body.”

• The decision offers cautionary lessons for boards negotiating executive compensation plans—but presents a unique fact situation. The case is distinguishable from virtually all others in the sheer magnitude of the compensation plan for Musk (as the court put it, “the incredible size of the biggest compensation plan ever—an unfathomable sum”). In addition, in the court’s view, none of the individuals involved in the process were independent of Musk, the Compensation Committee never even questioned whether the outsized compensation was necessary to retain and incentivize Musk, and there was no negotiation “at all” with Musk.

• The case highlights the drawbacks of a compensation committee not being comprised of at least one clearly independent director. In this case, the two Committee members, although purportedly independent, had strong business and personal ties to Musk. We note that if the Committee had been clearly independent and the company’s proxy disclosure had been adequate, then the approval by minority stockholders would have been fully informed and the plan could have been subject to business judgment deference under MFW, or at least the burden of proof under entire fairness review would have been on the plaintiff.

• The court emphasized that Musk already had been very well rewarded for his efforts at Tesla through the increased value of his pre-existing 21.9% equity interest.  The court noted the “many examples” of other “Superstar CEOs” (“Zuckerberg, Bezos, Gates, and others”), with large pre-existing equity holdings, “foregoing compensation entirely.”

Background. Musk made an initial proposal setting forth the terms of his compensation plan, and that proposal was the only one that was seriously considered by the Compensation Committee until Musk unilaterally changed the proposal six months later to reduce the compensation (describing the change as “me negotiating against myself”). The compensation plan provided Musk the opportunity to obtain, over ten years, 12 total tranches of options, each representing 1% of Tesla’s total outstanding shares. For a tranche to vest, Tesla’s market capitalization had to increase by $50 billion and Tesla had to achieve certain EBITDA or revenue targets in four consecutive fiscal quarters. The board viewed the plan as providing Musk with an additional 6% equity interest in exchange for $600 billion of growth in stockholder value. The plan was “250 times larger than the contemporaneous median peer compensation plan and over 33 times larger than the plan’s closest comparison, which was Musk’s prior compensation plan.”

At the time the plan was being considered, Musk divided his time between Tesla and SpaceX (which he had founded and where he served as CEO, CTO and board Chair). He also had founded, held executive positions at, and spent time at OpenAI, Neuralink, and The Boring Company. Just prior to the board’s approval of the plan, Musk entered into a settlement agreement with the SEC relating to his tweeting practices; and settled litigation with Twitter by agreeing to fulfill his obligation under a merger agreement to acquire Twitter. Both ISS and Glass Lewis recommended that stockholders vote against the compensation plan. Stockholders approved the plan, however, with 73% of the outstanding shares (excluding Musk’s and his brother’s shares) voting in favor.

Almost all the market capitalization and operational milestone targets in the plan were met by mid-2022, and Musk accordingly was granted shares under the plan (the “Grant”). The plaintiff brought suit claiming that the Tesla directors breached their fiduciary duties by approving the plan. Following trial and post-trial briefing, Chancellor Kathaleen St. Jude McCormick ruled in the plaintiff’s favor, and ordered as the remedy rescission of the entire compensation plan.

Discussion

Musk was a controller. The court concluded that Musk had “enormous influence over Tesla” to the point that he was the company’s controller, at least with respect to the compensation plan. The court found that Musk exercised “influence over managerial decisions, decision makers, and the process” relating to the compensation plan—indeed that, based on “an avalanche of evidence,” he “wielded the maximum influence that a manager can wield over a company.” Specifically:

• Ownership stake. Musk owned a 21.9% stake in the company—which was a “significant but not dispositive indicium of control.” (In this regard, the court noted Vice Chancellor Laster’s analysis in Voigt v. Metcalf (2020), which demonstrated from a mathematical and practical point of view the voting power represented by less-than-majority stakes. For example, if a 21.9% block favors a particular outcome, then the holder will win as long as holders of approximately one-in-three shares vote the same way, whereas, an opponent would have to garner about 71% of the unaffiliated shares to win.)
• Superstar status. Musk was a “Superstar CEO”—that is, there was a general belief in his “singular importance” to Tesla, and “extraordinary faith” in him. Superstar status tends to “shift the balance of power,” particularly when dealing with issues concerning the CEO’s personal interests, and may “create a distortion field that interferes with board oversight.”
• Business and personal ties. Musk had strong ties to three of Tesla’s eight directors (who, together with him, comprised half the board)—such that they were “beholden to Musk.”
• Positions. Musk was CEO, Chair and founder—“the most powerful trifecta of roles.”
• Authority. Musk “exercised managerial authority over all aspects of Tesla and often without regard to Board authority, rendering Tesla highly dependent on him.”
• Intertwined. Musk was “intertwined” with the company, “almost in a Mary Shelley (‘You are my creator’) sort of way”;
• Corporate strategy. Tesla’s “entire corporate strategy [was] Musk’s brainchild.”
• Admissions. Musk had not disputed Tesla’s public disclosures that Tesla was highly dependent on him; and had admitted having “the power to direct operational decisions.” Without consulting the board, he had “appointed himself ‘Technoking’—a position he compared to being a monarch.”

The court found that the price was unfair. The court noted the defendants’ assertions that Musk was “uniquely motivated by ambitious goals” and that “Tesla desperately needed Musk to succeed in its next stage of development.” However, the court stated, the defendants did not establish that these facts justified “the largest compensation plan in the history of public markets.” The court wrote: “There is simply no evidence that the ‘added incentive’ provided by a Grant of this magnitude was necessary, much less fair. This unique circumstance and this unique CEO do not support a finding of fair price.”

The court found that the board’s process was unfair. The directors contended that their objectives in approving the outsized compensation plan were to retain Musk at Tesla (and avoid his attention being diverted to his other companies and projects); and to incentivize him to achieve ever-higher levels of transformative growth for the company, which had already experienced transformative growth. The court emphasized, however, that the board never asked the following key question: “Was the plan even necessary for Tesla to retain Musk and achieve its goals?” The court stressed that the defendants: did not consider that Musk’s 21.9% equity interest alone gave him enormous incentive to achieve the plan’s market capitalization milestone targets; did not take into account that Musk had said he had no intention of leaving Tesla; and never considered asking Musk to agree to commit a specified amount of time to Tesla.

Moreover, the court stated, the Committee members and others involved in the process, all of whom had strong ties to Musk, let him dictate the timetable for the process; did not negotiate over the size or terms of the plan; and failed to require and consider a traditional benchmarking analysis (which “would have revealed the unprecedented nature of the…plan”). The witnesses “said it all,” the court stated, when in their testimony they “effectively admit[ed] that they did not view the process as an arm’s length negotiation….”

The defendants asserted that the process was “extensive and thorough,” citing its duration of nine months and the ten board and committee meetings held. The court, however, cited a “lack of substantive work” done. The court observed that most of the work on the plan had “occurred during small segments of those nine months”; Musk had dictated the timing of the process; and Musk had made last-minute changes to the timeline or altered substantive terms immediately prior to six out of the ten meetings during which the plan was discussed.

The court rejected the defendants’ approach to the process. The defendants viewed their process as appropriate given Musk’s unique importance to the company, his unique personality, his other strong interests and passions, and the unique point of time in the company’s development. They argued that the extremely ambitious mileposts in the plan meant that the plan provided “all upside” for the stockholders, while leaving Musk at risk of not earning any compensation. The court, however, emphasized that Musk’s 21.9% ownership stake already “gave him every incentive to push Tesla to levels of transformative growth—Musk stood to gain over $10 billion for every $50 billion in market capitalization increase.”

The court also observed that while the defendants argued that the milestone targets were extremely ambitious and risky, the board had calculated a 70% likelihood that they would be achieved. Also, while the defendants argued that the size of the plan was required to incentivize Musk to devote attention to Tesla by providing him with sufficient compensation so that he could pursue his passions, those passions involved other companies and projects (primarily, colonizing Mars to save humanity). In addition, the court rejected the defendants’ testimony that Musk was not asked to make a minimum time commitment to Tesla because it would have been “silly” and “like saying goodbye to Elon.” The court responded: “The court will never know because the Committee and its advisors never had the gumption to give it even the weakest of tries.”

Musk had extensive ties with the individuals tasked with negotiating the plan on Tesla’s behalf. He had a 15-year business and personal relationship with the Compensation Committee chair. The other Compensation Committee member, who was placed on a working group for the compensation plan, had a 20-year business relationship with Musk and their families vacationed together on a regular basis. The working group also included management members who were beholden to Musk, such as Tesla’s General Counsel, “who was Musk’s former divorce attorney and whose admiration for Musk moved him to tears during his deposition.” The court stated that the General Counsel “was a primary go-between Musk and the committee, and it [was] unclear on whose side [he] viewed himself. Yet many of the documents cited [by the defendants]…as proof of a fair process were drafted by [him].”

The court ordered rescission of the compensation plan in its entirety. Rescission “is the preferable remedy for breaches of fiduciary duty when rescission can restore the parties to the position they occupied before the challenged transaction,” the court wrote. In this case, rescission could achieve that result, as “no third-party interests [were] implicated, and the entire compensation plan [sat] unexercised and undisturbed.” As to the defendants’ contention that rescission would be “a harsh consequence that would leave Musk uncompensated,” the court wrote: “But Musk’s preexisting equity stake provided him tens of billions of dollars for his efforts.” As the defendants “failed to identify any logically defensible delta between the unfair Grant and a fair one,” there was “nothing in the record to allow the court to fashion a remedy that would order rescission only to the extent the Grant was unfair.”

Practice Points

• Generally, a board (or compensation committee) should actively negotiate an executive’s compensation plan.
  • The board should not view its role as engaging in a collaborative exercise with, or as acting as an advisor to, the executive. The objective should not be to provide the executive with whatever the executive wants. Rather, the board should consider what compensation and terms are required to meet the board’s objectives, and what the executive would accept.
  • The board should take into consideration the executive’s equity stake when determining how compensation will incentivize the executive.
  • If it seems that an executive (even if a controller) would be unlikely to agree to certain terms, the board should consider trying anyway, as, even if the term is rejected, the ask potentially can change the negotiating dynamic.
  • The board should: maintain a record establishing its objectives and negotiating efforts with respect to a compensation plan; consider proposing terms to the executive rather than having the executive propose them; and keep control of the timetable—or should document the business reasons for doing otherwise.
  • In litigation in which a plan or grant is challenged, in addition to defending the overall fairness, defendants should consider seeking to reduce the risk of a remedy requiring disgorgement of the entire amount by identifying the portion of the plan or grant that is most defensible.

• When possible, a compensation committee should be comprised of at least one director who is clearly independent. Also, committee members and management should understand that their role is to negotiate on behalf of the company, not to function as an ally for the executive.

• Generally, a board should evaluate a traditional benchmarking study when deciding on a compensation plan—even if peer companies are not readily identifiable and it appears market comparables would not be useful.

• An equity stake around 20% may be viewed as an indication of potential control. This level of equity stake not only provides a “sizable leg-up for stockholder votes,” but provides “a powerful rhetorical card to play in the boardroom,” the court wrote in Tornetta. It should be kept in mind that such an equity stake may be a significant factor in determining whether a stockholder has control, where there are other indications of control none of which standing alone might be sufficient to establish control.

• Emails, emails, emails…and jokes. The 201-page Tornetta opinion contains 939 footnotes, many of which quote from internal emails of Tesla directors and executives and are used to support or refute the plaintiff’s claims. It cannot be emphasized enough that emails, although informal communications, should be drafted with the same care as formal corporate records. In addition, jokes should be avoided in the context of serious corporate matters. Musk testified that his giving himself the title Technoking “was intended as a joke.” The court wrote: “[B]ut that is a problem in itself. Organizational structures, including titles, promote accountability by clarifying responsibilities. They are not a joke.” We note, as another example, that the court considered in its control analysis an email from a director to Musk which suggested that they have a romantic dinner together, but the court concluded that the email did not inform the analysis as it was “just a bad joke.”