The Delaware Law Series


Delaware’s Status as the Favored Corporate Home: Reflections and Considerations

Amy Simmerman, William B. Chandler III, and David Berger are Partners at Wilson Sonsini Goodrich & Rosati. This post is based on a Wilson Sonsini memorandum by Ms. Simmerman, Mr. Chandler, Mr. Berger, Brad Sorrels, and Ryan Greecher and is part of the Delaware Law series; links to other posts in the series are available here.

In recent months, a conversation has emerged as to whether Delaware should remain the favored state of incorporation for business entities. Indeed, many of our clients have asked us whether they should remain in Delaware or choose Delaware as the state of incorporation for their new ventures. In this discussion, we provide our reflections on that question and various factors that entrepreneurs, investors, and companies should consider when weighing incorporation in Delaware against incorporation in another state.

The Reliance on Delaware Compared to Other States

The sheer number of entities formed in Delaware reflects its dominance in this area. In 2022, more than 313,650 entities were formed in the state of Delaware, resulting in more than 1.9 million entities total in Delaware.[1] Delaware also continues to be the state of incorporation for nearly 68.2 percent of the Fortune 500, 65 percent of the S&P 500,[2] and approximately 79 percent of all U.S. initial public offerings in calendar-year 2022.[3] Of course, those numbers reflect that a substantial portion of entities are incorporated elsewhere, both within and outside of the United States. The Chief Justice of Delaware’s Supreme Court has noted that business entities indirectly or directly generate about a third of the state’s revenue.[4]

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Chancery Addresses Fiduciary Duty Claims Arising from Reincorporation to Nevada

Amy Simmerman, Brad Sorrels, and David Berger are Partners at Wilson Sonsini Goodrich & Rosati. This post is based on a Wilson Sonsini memorandum by Ms. Simmerman, Mr. Sorrels, Mr. Berger, Joe Slights, and Tiphanie Cascella and is part of the Delaware Law series; links to other posts in the series are available here.

On February 20, 2024, Vice Chancellor J. Travis Laster of the Delaware Court of Chancery issued an opinion refusing to dismiss stockholder claims challenging the reincorporation of TripAdvisor from Delaware to Nevada and determining that the entire fairness standard of judicial review, rather than the business judgment rule, applied to the decision to reincorporate. The essence of the court’s determination was that the purpose of the reincorporation was to reduce stockholder litigation risks for its fiduciaries and that a reduction in the litigation rights of stockholders in a controlled company creates a non-ratable benefit for the controller. Accordingly, the standard of review governing the transaction is entire fairness unless the company uses some type of procedural protections, such as approval by an independent board committee and/or minority stockholders, to lower the standard of review by simulating an arm’s-length negotiation. Because no such steps were taken here, the court denied the defendants’ motion to dismiss and allowed the case to proceed under the entire fairness standard.

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2023 Delaware Corporate Law and Litigation Year in Review

Amy Simmerman is a Partner, Ryan Hart is an Associate, and Angie Flaherty is a Senior Counsel at Wilson Sonsini Goodrich & Rosati. This post is based on a WSGR memorandum by Ms. Simmerman, Mr. Hart, Ms. Flaherty, and Sarah Hand and is part of the Delaware law series; links to other posts in the series are available here.

Introduction

In 2023, the Delaware courts issued many decisions addressing an array of important topics, including director and officer oversight obligations, the role of boards in navigating environmental, social, and governance (ESG) issues, dual-class stock structures and controlling stockholder conflicts of interests, structuring and process considerations for mergers and acquisitions, the enforceability of advance notice bylaws in the face of stockholder activism, and governance matters in the venture-backed company context. The Delaware General Corporation Law (the DGCL) was also updated in certain significant ways. Our 2023 Delaware Corporate Law and Litigation Year in Review surveys the cases and developments that should be of most interest to boards, management, and investors for both public and private companies, and highlights important takeaways from them.

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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.

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Chancery Invalidates Elon Musk’s $55.8 Billion Equity Compensation Package

Sean Feller and Krista Hanvey are Partners, and Christina Andersen is Of Counsel at Gibson, Dunn & Crutcher LLP. This post is based on their Gibson 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 Executive Compensation in Controlled Companies (discussed on the Forum here) by Kobi Kastiel.

This is a landmark decision under Delaware law that raises important considerations for Boards and independent directors when deciding upon significant compensation awards.

In a 200-page decision following a five-day trial, Chancellor Kathaleen McCormick of the Delaware Court of Chancery ruled in favor of Tesla stockholders who had brought a derivative lawsuit challenging the multiyear compensation arrangement awarded to Tesla CEO Elon Musk.[1] The plaintiff-stockholders alleged that Tesla’s directors breached their fiduciary duties by awarding Musk performance-based stock options in January 2018 with a potential $55.8 billion maximum value and a $2.6 billion grant date fair value (the “Grant”). The Court found that the defendants—Musk, Tesla, Inc. and six individual directors—failed to meet their burden to prove that the Grant was “entirely fair,” the standard under Delaware law that the Court applied in light of the Court’s determination that Musk held controlling stockholder status with respect to the Grant.  As a remedy, the Court ordered the complete rescission of the Grant, which had been approved by a majority vote of disinterested stockholders.[2] The Court opened its opinion by asking:  “Was the richest person in the world overpaid?”  And the Court concluded that, yes, he was:  “In the final analysis, 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.”[3]

The Grant

On January 21, 2018, Tesla’s Board of Directors (the “Board”)[4] unanimously approved the Grant, which would vest based on Tesla’s achievement of certain market capitalization goals, as well as operational milestones related to revenue and adjusted EBITDA targets.  The Grant was “the largest potential compensation opportunity ever observed in public markets by multiple orders of magnitude—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.”[5]

The Board conditioned the Grant on approval by a majority vote of disinterested stockholders. A February 8, 2018 proxy statement (the “Proxy”) notified stockholders of a vote on the Grant, which was held on March 21, 2018.  Despite ISS and Glass Lewis recommending votes against approval of the Grant, stockholders (excluding Musk’s and his brother’s ownership) approved the Grant with 73% in favor.  The Grant began vesting in 2020; as of June 30, 2022, the Grant was nearly fully vested, with all market cap and adjusted EBITDA milestones achieved, and three revenue milestones achieved, with one more deemed probable of achievement.[6]

Court found stockholder vote approving the Grant was not fully informed

The Court determined that it was “undeniable that, with respect to the Grant, Musk controlled Tesla”[7] and, therefore, that the Board’s approval of the Grant was a conflicted-controller transaction.  As a result, the Board’s decision would be examined under an “entire fairness” standard―the Delaware courts’ “most onerous standard of review.”[8] However, Delaware law allows defendants facing an entire fairness standard to shift the burden of proof to the plaintiff by showing that the transaction was approved by a fully informed vote of the majority of the minority stockholders.

The Court found that the stockholder vote approving Musk’s Grant was not fully informed for two reasons:

  • the Proxy inaccurately described key directors as independent, when several of them had extensive personal and professional relationships of long duration with Musk, including owing much of their personal wealth to Musk; and
  • the Proxy misleadingly omitted details about the process by which Musk’s Grant was approved, including material preliminary conversations between Musk and the Compensation Committee chairman, as well as Musk’s role in setting the terms of the Grant and the timing of the Committee’s work.

The Court concluded:  “Put simply, neither the Compensation Committee nor the Board acted in the best interests of the Company when negotiating Musk’s compensation plan. In fact, there is barely any evidence of negotiations at all. Rather than negotiate against Musk with the mindset of a third party, the Compensation Committee worked alongside him, almost as an advisory body.”[9]

The “extraordinary nature of the Grant”[10]

In addition to the process of approving the Grant, the Court considered its “price.”  “The Board never asked the $55.8 billion question:  Was the plan even necessary for Tesla to retain Musk and achieve its goals?”[11]  The Court concluded that it was not for three key reasons:

  • Musk already owned 21.9% of Tesla, which ownership stake gave him incentive to push Tesla to grow its market capitalization even without the additional compensation;
  • there was no risk that Musk would depart Tesla without receiving the Grant, nor did the Board condition the package on Musk devoting any set amount of time to Tesla; and
  • the Grant’s performance conditions were not, in fact, ambitious and difficult to achieve.[12]

It was also significant to the Court that the Grant process lacked a traditional benchmarking analysis.[13] “The incredible size of the biggest compensation plan ever—an unfathomable sum—seems to have been calibrated to help Musk achieve what he believed would make “a good future for humanity” [related to Musk’s goal of colonizing Mars]. …. [T]hat had no relation to Tesla’s goals with the compensation plan.”[14]

Observations and Considerations for Boards and Independent Directors

Much of Chancellor McCormick’s decision may be unique to the “Superstar CEO”[15] status that Musk holds and the facts and circumstances at Tesla and its Board, as well as the Court’s determination (for the first time in the Chancery Court) that Musk was a controlling stockholder. Nevertheless, the decision is a landmark one under Delaware law and raises important considerations for Boards and independent directors when deciding upon significant compensation awards.

  1. Document the Process. The Court was very focused on the rushed, casual decision-making of Tesla’s Compensation Committee.  In their testimony, several Board members said they couldn’t remember meetings where important elements of the Grant were discussed.  If considering a significant award, boards and compensation committees would be better served by undertaking a thorough analysis, including rigorous benchmarking, and documenting that process through e-mails, detailed meeting minutes, formalized presentations, and other written records.
  2. Awards Should Have Clear Rationales. Musk’s award had no mechanism for actually keeping his attention focused on Tesla, as opposed to his other business interests.  While the extent of Musk’s outside interests may be a distinguishing factor, compensation committees going forward should be mindful of the concerns the Court expressed around that issue and consider whether and how to ensure that significant awards to executives are clearly and closely aligned to the Company’s business objectives. Performance conditions for such awards will also be analyzed in retrospect so boards should be sure to pressure test the rigor of those goals and contemporaneously document why goals were determined to be challenging.
  3. Expect Extra Scrutiny of Independent Directors. The Court was particularly disturbed by the close personal and business relationships of Tesla’s Compensation Committee members with Musk, such that they viewed awarding the Grant as a collaborative process with Musk, rather than an arm’s length negotiation.  Expect, when considering significant compensation awards, that all elements of an independent director’s connections with the executive-grantee—including length of board service—to be closely examined for indicia of objectivity.

Endnotes

1Richard J. Tornetta et al. v. Elon Musk et al., case number 2018-0408, in the Court of Chancery of the State of Delaware.(go back)

2The Court noted that Musk had not yet exercised any of the options underlying the Grant. Opinion at 8.(go back)

3Opinion at 7.(go back)

4Tesla’s nine-person Board included Musk, his brother Kimbal Musk, Brad W. Buss, Robyn M. Denholm, Ira Ehrenpreis, Antonio J. Gracias, Steve Jurvetson, James Murdoch, and Linda Johnson Rice. Tesla’s Compensation Committee was comprised of Ehrenpreis (the committee chair), Buss, Denholm and Gracias.(go back)

5Opinion at 1.(go back)

6Opinion at 92.(go back)

7Opinion at 112.(go back)

8Opinion at 104.(go back)

9Opinion at 128.(go back)

10Opinion at 143.(go back)

11Opinion at 6.(go back)

12Opinion at 183.(go back)

13Opinion at 144.(go back)

14Opinion at 180.(go back)

15Opinion at 120.(go back)

Common Venture Capital Investors and Startup Growth

Ofer Eldar is Professor of Law, and Jillian Grennan is an Associate Adjunct Professor of Finance and Sustainability at the University of California, Berkeley. This post is based on their article forthcoming in the The Review of Financial Studies.

Venture capital (VC) investors play an important role in advising, monitoring, and providing expertise to entrepreneurial startups. VC investors typically have substantial control rights, and actively seek to constrain managerial discretion over key decisions through the appointment of board representatives. A key, yet often overlooked, feature of VC investments is that VC portfolios tend to include many startups in the same industry. In fact, the rate of startups in the same industry with a common VC investor has risen dramatically in recent years (Eldar and Grennan 2021). Most startups nowadays share a VC investor with at least one other startup in the same industry. Even startups that operate in the same line of business, such as Uber and Lyft, often raise capital from the same VC investors.

In our paper, Common Venture Capital Investors and Startup Growth, published in the Review of Financial Studies, we explore the relation between common VC investment and startups’ trajectory for growth and success. On one hand, VC investors could play favorites by diverting valuable competitive information from one startup to another. Startups that operate in complementary spaces within the same industry (such as software and media) may seek similar business opportunities, whether developing a new service or pursuing an attractive contract, and there is a risk that VCs will favor some startups at the expense of others. On the other hand, VC investors can act as incubators for valuable information and expertise. The expertise acquired through common investments at the industry level could benefit all portfolio companies and maximize VC investors’ returns. VCs can allocate different business opportunities efficiently to the startups that, based on the common VC’s information, are best positioned to pursue them.

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Chancery Finds Tesla Board Breached Fiduciary Duties

Gail Weinstein is Senior Counsel, and Philip Richter and Steven Epstein are Partners at Fried, Frank, Harris, Shriver & Jacobson LLP. This post is based on a Fried Frank memorandum by Ms. Weinstein, Mr. Richter, Mr. Epstein, Steven Steinman, Peter Simmons, and Jeffrey Ross 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 Executive Compensation in Controlled Companies (discussed on the Forum here) by Kobi Kastiel.

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.

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Caremark Claim Based on Business Risks Dismissed

Richard Horvath and Stephen Leitzell are Partners, and Taylor Jaszewski is an Associate at Dechert LLP. This post is based on a Dechert memorandum by Mr. Horvath, Mr. Leitzell, Mr. Jaszewski, and Christopher Merken; 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 Monetary Liability for Breach of the Duty of Care? (discussed on the Forum here) by Holger Spamann.

Key Takeaways

  • The Court of Chancery continues its consideration of whether a director or officer’s oversight duties, set forth in the seminal case of In re Caremark International Inc. Derivative Litigation[1] and its progeny, apply to business risks in addition to legal compliance.
  • The Court’s recent decision in Segway, Inc. v. Cai squarely concludes that an officer does not face oversight liability for alleged inattention to day-to-day business matters or routine business risks.

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Tornetta v. Musk: Post-Trial Opinion

This post provides the text of the post-trial opinion regarding the case between Richard J. Tornetta on behalf of Tesla, Inc. against Elon Musk, decided by the Delaware Court of Chancery on January 30, 2024. This post is part of the Delaware law series; links to other posts in the series are available here.

IN THE COURT OF CHANCERY OF THE STATE OF DELAWARE

RICHARD J. TORNETTA, Individually

and on Behalf of All Others Similarly

Situated and Derivatively on Behalf of

Nominal Defendant TESLA, INC.,

Plaintiff,

v.

ELON MUSK, ROBYN M. DENHOLM,

ANTONIO J. GRACIAS, JAMES

MURDOCH, LINDA JOHNSON RICE,

BRAD W. BUSS, and IRA

EHRENPREIS,

Defendants, and

TESLA, INC., a Delaware Corporation,

Nominal Defendant.

POST-TRIAL OPINION

Date Submitted: April 25, 2023

Date Decided: January 30, 2024

Gregory V. Varallo, Glenn R. McGillivray, BERNSTEIN LITOWITZ BERGER & GROSSMANN LLP, Wilmington, Delaware; Jeroen van Kwawegen, Margaret Sanborn-Lowing, BERNSTEIN LITOWITZ BERGER & GROSSMANN LLP, New York, New York; Peter B. Andrews, Craig J. Springer, David M. Sborz, Andrew J. Peach, Jackson E. Warren, ANDREWS & SPRINGER LLC, Wilmington, Delaware; Jeremy S. Friedman, Spencer M. Oster, David F.E. Tejtel, FRIEDMAN OSTER & TEJTEL PLLC; Bedford Hills, New York; Counsel for Plaintiff Richard J. Tornetta.

David E. Ross, Garrett B. Moritz, Thomas C. Mandracchia, ROSS ARONSTAM & MORITZ LLP, Wilmington, Delaware; Evan R. Chesler, Daniel Slifkin, Vanessa A. Lavely, CRAVATH, SWAINE & MOORE LLP, New York, New York; Counsel for Defendants Elon Musk, Robyn M. Denholm, Antonio J. Gracias, James Murdoch, Linda Johnson Rice, Brad W. Buss, and Ira Ehrenpreis.

Catherine A. Gaul, Randall J. Teti, ASHBY & GEDDES, P.A., Wilmington, Delaware; Counsel for Nominal Defendant Tesla, Inc.

McCORMICK, C.

Was the richest person in the world overpaid? The stockholder plaintiff in this derivative lawsuit says so. He claims that Tesla, Inc.’s directors breached their fiduciary duties by awarding Elon Musk a performance-based equity-compensation plan. The plan offers Musk the opportunity to secure 12 total tranches of options, each representing 1% of Tesla’s total outstanding shares as of January 21, 2018. For a tranche to vest, Tesla’s market capitalization must increase by $50 billion and Tesla must achieve either an adjusted EBITDA target or a revenue target in four consecutive fiscal quarters. With a $55.8 billion maximum value and $2.6 billion grant date fair value, the plan is the largest potential compensation opportunity ever observed in public markets by multiple orders of magnitude—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. This post-trial decision enters judgment for the plaintiff, finding that the compensation plan is subject to review under the entire fairness standard, the defendants bore the burden of proving that the compensation plan was fair, and they failed to meet their burden.

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Kellner v. AIM ImmunoTech, Inc. provides key guidance on advance notice bylaw provisions

Andrew Freedman is Co-managing Partner and Chair of Shareholder Activism Practice, Lori Marks-Esterman is Executive Committee Member and Chair of Litigation Practice, and Adrienne Ward is Partner at Olshan Frome Wolosky LLP. This post is based on a Olshan memorandum by Mr. Freedman, Ms. Marks-Esterman, Ms. Ward, Ron Berenblat, and Rebecca Van Derlaske, and is part of the Delaware law series; links to other posts in the series are available here.

On December 28, 2023, Vice Chancellor Will of the Delaware Court of Chancery rendered an important decision in Kellner v. AIM ImmunoTech, Inc., which provides key guidance on advance notice bylaw provisions (“ANBs”). The Court found that four out of six of the amended ANBs at issue in the case were “overbroad, unworkable, and ripe for subjective interpretation by the Board,” and struck them down for running afoul of Delaware law. In so doing, Vice Chancellor Will noted the following about these four offensive ANBs:

Rather than further the identified purpose of obtaining transparency [through] disclosure, these provisions seem designed to thwart an approaching proxy contest, entrench the incumbents, and remove any possibility of a contested election.

Shareholder activists should be well-apprised of this decision as it provides useful guidance on the permissible scope of ANBs that their target companies have or may adopt. Nominating stockholders should review ANBs carefully for overly broad “stockholder associated persons” definitions in ANBs and seek advice on how to navigate them. For companies and boards, the decision serves as a warning that ANBs that are overbroad and ripe for subjective interpretation are not likely to withstand judicial scrutiny. See our Key Takeaways at the end of this Client Alert on the practical impact this decision may have on shareholder nominations.

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