By Andrew J. Czerkawski
I. Background and Posture
In the summer of 2018, after the directors of Tesla, Inc. (“Tesla”) awarded fellow board member Elon Musk (“Musk”) a compensation package worth potentially $55.8 billion, shareholder Richard Tornetta (“Tornetta”) brought direct and derivative claims against Musk and all eight other board members asserting, inter alia, fiduciary duty breaches.[1] Vesting in twelve tranches, the compensation package granted Musk stock options (1% of total shares outstanding) conditioned on Tesla organically achieving market capitalization and revenue milestones; if no tranches vested, then Musk earned nothing.[2] The board moved for, but the court denied, a Rule 12(b)(6) dismissal.[3]
II. Discussion
A. Judicial Skepticism Outweighs Board Deference
Presenting a Delaware law first impression, Vice Chancellor Slights considered the case’s threshold, and often dispositive, applicable standard of review question.[4] Acknowledging the divergent degrees of judicial deference and their consequences on high-stakes corporate litigation costs, the court recognized that fiduciary claims reviewed for entire fairness generally advance past the pleadings stage; business judgment review often ends them at the “proverbial starting line.”[5] Citing former Chief Justice Leo E. Strine’s 2005 Delaware Journal of Corporate Law article, the court weighed the competing concerns at hand: on the one, Delaware law affords board executive compensation decisions “great deference”; on the other, transactions with conflicted controlling shareholders “provoke heightened judicial suspicion.”[6] And the court noted that the otherwise afforded judicial deference does not “jibe” with its “reflexive suspicion” of conflicted controller transactions.[7]
B. Controlling Shareholders Wield Inherently Coercive Power
Before awarding Musk the compensation package, Tesla’s board, though under neither a statutory nor bylaw obligation to do so, expressly conditioned the grant’s effectiveness on receiving a majority of the disinterested—non-Elon or fellow board member and brother Kimbal Musk—shares’ approval; at that time Musk’s ownership interest amounted to just shy of 22% total shares outstanding.[8] At a special meeting, 73% of present disinterested shares (the proxy explained that the structure considered non-votes as having no effect, rather than as a no) approved Musk’s compensation award, equating to a roughly 47% total disinterested outstanding share approval.[9]
The defending board contended this ratifying vote “ratcheted” any otherwise applicable elevated judicial scrutiny down to business judgment review.[10] But Tornetta asserted the shareholder ratification’s “cleansing effect” requires approval from an affirmative majority of all the disinterested outstanding shares, “not a mere majority of whatever subset of disinterested shares” that actually vote, and thus Musk’s compensation award approval vote—47% of total disinterested outstanding shares—fell short.[11] Though observing that “in the ordinary course . . . [Tesla’s] stockholder vote would justify business judgment deference[,]” the court, analogizing to the criminal death penalty, observed that Delaware’s corporate fiduciary jurisprudence considers that conflicted controller transactions are, “in a word, ‘different.’”[12]
Though addressed in a different context, over twenty years ago (then) Vice Chancellor Strine likened a controlling shareholder to an “800-pound gorilla” and, for fear of retribution if it did not get its way, recognized the gorilla’s inherently coercive power over the potentially “hand-picked” (or at least supported) directors and the other minority shareholders (the “less powerful primates”).[13] Echoing Leo Strine’s whimsical analogy, the Tornetta court observed that corporate transactions benefitting its own controlling shareholder—“‘the 800-pound gorilla’”—raises the specter that “even putatively independent directors may owe or feel a more-than-wholesome allegiance to the interests of the controller, rather than to the corporation and its public stockholders.’”[14] And despite characterizing board decisions fixing executive compensation as “about as work-a-day as board decisions get[,]” as opposed to fundamental changes, the court nevertheless concluded that the gorilla’s inherently coercive power potentially influencing the board’s and stockholders’ voting decisions mandated pleadings-stage entire fairness review.[15]
C. Musk Controls Tesla (?)
The court’s pleadings-stage entire fairness standard of review determination both turned on and presupposed the degree of Musk’s control over Tesla.[16] Yet, curiously, rather than dispute it, the defending board acknowledged, solely for 12(b)(6) purposes, Musk’s domination over the board during the compensation package’s negotiation and approval.[17] In a footnote, the Vice Chancellor observed the defendants’ awkward position.[18] At the pleadings stage in a prior, unrelated suit challenging Tesla’s acquisition of the solar energy company SolarCity, Vice Chancellor Slights found the Tesla shareholder plaintiffs adequately plead that Musk controlled Tesla’s board and denied the directors’ 12(b)(6) dismissal motion.[19] In Tornetta, Vice Chancellor Slights recognized the shareholder plaintiff (Tornetta) alleged the same facts as the Tesla-SolarCity plaintiffs and noted the defending board, though it disputed in principle that Musk controlled Tesla, “out of deference to the [Tesla-SolarCity case],” argued (for 12(b)(6) purposes only) as if he did.[20] Despite the court finding, based on Musk’s assumed conflicted controller status, entire fairness review appropriately applied at the pleadings stage, Vice Chancellor Slights nevertheless left the door open for a contrary determination “down the road[.]”[21]
D. MFW’s Framework Applies to Conflicted Executive Compensation Transactions
Though it ultimately held otherwise, the court nevertheless laid the groundwork for theoretically procuring pleadings-stage business judgment review of conflicted controller executive compensation awards.[22] Invoking its twin-pronged procedural protections, the Vice Chancellor suggested MFW provided a “roadmap” thereto.”[23] In landmark MFW, the Delaware Supreme Court articulated a multi-part framework that affords defending fiduciaries business judgment deference in the context of freeze-out mergers.[24] Because a controlling shareholder’s inherently coercive influence potentially infects and undermines the DGCL’s twin default statutory merger protections—i.e., approval from both (1) a disinterested board and (2) an affirmative majority of the shareholders—Delaware courts review the transaction under corporate law’s most exacting scrutiny: entire fairness.[25] And a pleadings-stage finding that entire fairness review applies normally precludes a Rule 12(b)(6) dismissal.[26] But if the controller “irrevocably and publicly” abandons its power to determine the merger’s outcome (via controlling the board’s negotiations and the shareholders’ approval), then the transaction integrates and harmonizes the unadulterated dual statutory protections.[27] Thus, if the controlled transaction replicates an arm’s-length, disinterested third-party, market deal (essentially fulfilling entire fairness review’s role and purpose), then the court forgoes the otherwise applicable exacting review standard and deferentially looks only for a rational business purpose.[28]
The Tornetta court, though opining somewhat hypothetically and acknowledging the distinct transactional scenarios, intimated that if Tesla’s board utilized MFW’s bulwark prerequisites—i.e., from the outset of Musk’s compensation award’s “substantive economic negotiations” the board ensured that (1) an informed, fully empowered, independent special committee, and (2) an informed, uncoerced, affirmative majority of the disinterested stockholders both approved the award—then the board would assuage the court’s “reflexive suspicion” of the 800-pound gorilla’s inherently coercive power.[29]
III. Practical Takeaway
Depending on the case’s ultimate outcome, boards may face increased exposure in the executive compensation space. To counterpoise the potentially increased risk, directors planning to follow in Tesla’s footsteps and award their influential, face-of-the-company executives extremely high-risk, high-reward compensation packages—numbers that would furrow a reasonable investor’s brow or leave a conservative investor’s mouth agape—should consider adopting and implementing (or tightening up already existing) governance measures designed to ensure strict compliance with MFW’s protective regimen, not only in transformational contexts, but also when compensating their officers. Lax adherence thereto likely triggers pleadings-stage entire fairness application and thus precludes a Rule 12(b)(6) dismissal, prompting costly, lengthy, and risky continued entire fairness litigation. And entire fairness review jeopardizes unique, “heart-stopping”[30] compensation awards. Corporations may struggle to attract and retain extraordinary executive talent if their board’s compensation decisions, and thus their executives’ incentive to build commensurate shareholder value, remain susceptible to potentially vitiative judicial inspection.
[1] See Tornetta v. Musk, 250 A.3d 793, 796, 801, 803–04 (Del. Ch. 2019).
[2] See id. at 803–04.
[3] Id. at 796, 803, 814; Del. Ch. Ct. R. 12(b)(6) (“[F]ailure to state a claim upon which relief can be granted”).
[4] Tornetta, 250 A.3d at 797.
[5] Id.
[6] Id; Leo E. Strine, Jr., The Delaware Way: How We Do Corporate Law and Some of the New Challenges We (and Europe) Face, 30 Del. J. Corp. L. 673, 678 (2005).
[7] See Tornetta, 250 A.3d at 798.
[8] Id. at 801, 804, 806–07.
[9] Id. at 804. 64% of Tesla’s total disinterested shares attended the special meeting, and 73% voted in favor. See Tornetta, 250 A.3d at 807 (explaining the vote percentages).
[10] Id. at 797.
[11] See id. at 808 (internal quotations omitted). Tornetta relied principally on then Vice Chancellor Strine’s opinion in In re PNB Holding Co. S’holders Litig., 32 Del. J. Corp. L. 654 (Del. Ch. 2006).
[12] Tornetta, 250 A.3d at 807, 807 n.95 (citing Chief Justice Leo Strine’s concurrence in Rauf v. State, 145 A.3d 430, 436 (Del. 2016) (“[D]eath is different.”)). Tesla’s board argued that the vote complied with DGCL section 216 governing “non-extraordinary stockholder action,” such as approving executive compensation, and thus warranted business judgment review. Tornetta, 250 A.3d at 806–07. And the court in part agreed, but rejected the notion that stockholder approval cleanses an otherwise well-plead breach of fiduciary duty in conflicted controller transactions. Id. at 807–08.
[13] See In re Pure Resources, Inc., S’holders Litig., 808 A.2d 421, 436 (Del. Ch. 2002).
[14] See Tornetta, 250 A.3d at 801 (citing Strine, supra note 6, at 678; Pure Resources, 808 A.2d at 436).
[15] See Tornetta, 250 A.3d at 796, 800, 809.
[16] Id. at 810 n.113.
[17] Tornetta, 250 A.3d at 801, 805.
[18] Id. at 797 n.5.
[19] In re Tesla Motors, Inc. S’holder Litig., 2018 WL 1560293, at *19 (Del. Ch. Mar. 28, 2018). Though the court in the next sentence recognized that “facts developed in discovery may well demonstrate otherwise.” Id.
[20] See Tornetta, 250 A.3d at 797 n.5. The court expressed that the defendants “would say they drew the wrong judge here.” Id. Moreover, the same Delaware counsel, David Ross, Garrett Moritz, and Benjamin Grossberg of Ross Aronstam & Moritz LLP, and the same out-of-state counsel, William Savitt of Wachtell, Lipton, Rosen & Katz, represented the same then-seven now nine Tesla board members in both cases. See Tornetta, 250 A.3 at 796 (listing counsel); Tesla Motors, 2018 WL 1560293, at *0 (listing counsel).
[21] Tornetta, 250 A.3d at 809–10, 810 n.113 (acknowledging the board will “challenge the factual bases” for the allegations of Musk’s control over Tesla and the board through discovery and might reiterate the issue at the summary judgment stage).
[22] Id. at 810–12.
[23] Id. at 810 (pointing to Kahn v. M & F Worldwide Corp., 88 A.3d 635 (Del. 2014) (MFW).
[24] MFW, 88 A.3d at 645. Establishing the test and describing its necessary conditions, the MFW court held that, in the freeze-out merger context, the court will apply the business judgment rule
if and only if: (i) the controller conditions the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders; (ii) the Special Committee is independent; (iii) the Special Committee is empowered to freely select its own advisors and to say no definitively; (iv) the Special Committee meets its duty of care in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority.
Id. (emphasis in original). Stated otherwise, the court will review a freeze out merger for business judgment if, from the outset, the controller conditions the merger on both of the following: (1) “the approval of an independent, adequately-empowered Special Committee that fulfills its duty of care”; and (2) “the uncoerced, informed vote of a majority of the minority stockholders.” Id.
[25] MFW, 88 A.3d at 644; see also 8 Del. C. § 251(b)–(c) (mandating that a merger between two domestic corporations requires both of the following: (1) the board adopt a resolution approving the merger agreement and (2) an affirmative majority of the total outstanding shares approve (or reject) it.
[26] Sciabacucchi v. Liberty Broadband Corp., 2018 WL 3599997, at *15 (Del. Ch. July 26, 2018) (citing Orman v. Cullman, 794 A.2d 5, 21 n.36 (Del. Ch. 2022) (discussing in a lengthy four paragraph long footnote Delaware corporate law’s contrasting standards of review)).
[27] See MFW, 88 A.3d at 644.
[28] See id; see also Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971) (articulating the business judgment standard of review: “[a] board of directors enjoys a presumption of sound business judgment, and its decisions will not be disturbed if they can be attributed to any rational business purpose.”).
[29] Tornetta, 250 A.3d at 812 (internal quotations omitted). Musk’s compensation award did not utilize MFW’s dual protections. Id.
[30] Evan Chesler, Esq., Partner, Cravath Swain & Moore LLP and Counsel for Defendants in Tornetta v. Musk, 2018-0408-KSJM (Del. Ch. 2018), Post-trial Oral Argument (Feb. 21, 2023).