Tornetta v. Musk is the Rule of Law at Work

Holger Spamann is the Lawrence R. Grove Professor at Harvard Law School. This post is based on his recent op-ed. Related research from the Program on Corporate Governance includes Executive Compensation as an Agency Problem and Pay without Performance: The Unfulfilled Promise of Executive Compensation both by Lucian A. Bebchuk and Jesse M. Fried; The Growth of Executive Pay by Lucian A. Bebchuk and Yaniv Grinstein; and The CEO Pay Slice (discussed on the Forum here) by Lucian A. Bebchuk, Martijn Cremers, and Urs Peyer.

In an op-ed in the Wall Street Journal on February 22, Gov. Jeb Bush and Joe Lonsdale have it exactly backwards when they complain that Tornetta v. Musk “imperil[s] the rule of law.” Messrs. Bush and Lonsdale misrepresent the case as “arbitrary enforcement” in violation of “equality before the law.” The aspects of Tornetta that Messrs. Bush and Lonsdale complain about, however, are just business as usual in U.S. corporate law. Tornetta does exactly what Messrs. Bush and Lonsdale want courts to do: it applies “equal justice” even to the most powerful, most vocal CEO alive.

(Messrs. Bush and Lonsdale also complain about New York Attorney General Letitia James’s fraud case against Donald Trump. I do not take a position on this. Unlike Messrs. Bush and Lonsdale, I prefer not to criticize in matters I do not know well.)

Messrs. Bush and Lonsdale’s chief complaint is that “judges have ordered massive punitive judgments on behalf of dubious or nonexistent ‘victims.’ … The plaintiff, Richard Tornetta, held nine shares in 2018—worth about $200 then and $2,000 today, after the execution of the compensation plan that supposedly injured him.”

Well, that is just how Delaware corporate law—and all U.S. law, for that matter—works, and for good reason. Large corporations pool the capital of many investors. If investors had to band together to sue the managers and other fiduciaries who are supposed to work for them, the collective action problem would be insurmountable. No suit would ever be brought. Fiduciaries could breach their duties in impunity. That is why the law allows individual shareholders to file complaints on behalf of the corporation and all the shareholders. Or to be more precise, it effectively allows plaintiff law firms to bring cases on behalf of nominal plaintiff shareholders. While many details of the practice of such “plaintiff litigation” are controversial, the principle is not.

Messrs. Bush and Lonsdale’s further complaint about the Delaware judgment grotesquely oversimplifies the case. They complain that “Chancellor Kathaleen McCormick of the Court of Chancery ordered the unwinding of five years of Mr. Musk’s incentive-based compensation at Tesla, which had been approved by 80% of the company’s shareholders. … Mr. Musk’s compensation plan awarded him stock bonuses tied to earnings and stock-value benchmarks, which many critics thought he could never meet. When he did, he received $56 billion, enriching shareholders like Mr. Tornetta along the way.” In her 201-page opinion, Chancellor McCormick found, however, that (1) the shareholder vote was not fully informed (i.e., not all relevant facts had been disclosed to the shareholders) and (2) the first couple milestones—entitling Mr. Musk to billions in compensation—were highly likely to be met soon after the grant, according to internal projections at the time. Chancellor McCormick did not invalidate Mr. Musk’s pay package simply because it was too high, even though Mr. Musk’s “stock bonuses tied to earnings and stock-value benchmarks” were estimated to be worth $2.6 billion on grant date—i.e., independent of any effort by Mr. Musk!—an order of magnitude larger than similar packages granted to CEOs at other large companies. That is the sort of nuance and respect for private ordering that Delaware’s corporate judiciary is justly famous for, and that has made Delaware’s the corporate law of choice in the U.S.

Rescinding Mr. Musk’s entire stock grant is the standard remedy in this case, even though the amount at stake—$56 billion—is decidedly not standard (because Mr. Musk’s compensation was decidedly not standard!). Procedurally, Chancellor McCormick could hardly have ruled otherwise because Mr. Musk’s lawyers never asked for anything but an all-or-nothing decision. In any event, full rescission is the accepted remedy under foundational precedents such as Guth v. Loft (Del. 1939). And for good reason. To be sure, Mr. Musk oversaw Tesla’s spectacular rise to a trillion dollar company and will get nothing for it if he forfeits his compensation. Tesla shareholders will get to have their cake and eat it too. But consider this. Imagine your broke cousin gains access to your bank accounts under false pretenses. Your cousin takes all your money to gamble at an illegal bookie. Your cousin is lucky and doubles the money. Would you be satisfied if the law merely required your cousin to return your money? Or even one and a half times your money? If so, your cousin would be playing “heads I win, tails you lose.” As would corporate fiduciaries when flaunting procedural constraints, if the maximum remedy were anything less than full recission.

There is much to discuss about Tornetta, but it isn’t what Messrs. Bush and Lonsdale think. The facts of the case are extraordinary, hence legal evaluation is difficult. At a recent online event that I co-organized, fifty of America’s leading corporate law professors debated various aspects of the case, some defending Chancellor McCormick’s decision, others critical. Some speculated if the case might have repercussions for Delaware’s attractiveness to strong-willed founders such as Mr. Musk, and if the Delaware Supreme Court might thus be inclined to cut back on Chancellor McCormick’s holding. None, however, even mentioned that the case could be about “blue-state politicians … ‘sticking it’ to Messrs. Trump and Musk,” as Messrs. Bush and Lonsdale would have it. That would be absurd, especially in Delaware. Delaware judges are independent, like all judges, but in addition to that, Art. IV § 3 of Delaware’s constitution requires partisan balance on all of Delaware’s courts. Moreover, Mr. Musk’s track record in blue state courts is quite favorable, even though he has repeatedly taken legal positions that are aggressive by all accounts. Just last year, Mr. Musk won important cases in Delaware about Tesla’s 2016 acquisition of SolarCity and in San Francisco about his 2018 “funding secured” tweet.

I wholeheartedly agree with Messrs. Bush and Lonsdale that a “dispassionate justice system” is crucial. But the test of such a system is whether it applies the same rules irrespective of the litigants, not whether certain litigants win or lose regardless of the facts. Tornetta passes this test with flying colors.

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