On January 30, 2024, more than a year after hearing five days of evidence at trial, Chancellor Kathaleen McCormick of the Delaware Court of Chancery issued her opinion (“Opinion”) in Tornetta v. Musk,¹ rescinding in full Tesla, Inc.’s (“Tesla”) $55.8 billion grant of options (the “Grant”) to its CEO, Elon Musk, which Tesla’s public stockholders had resoundingly approved following the recommendation of the Board of Directors of Tesla (the “Board”).  In sum, the Court held that: (i) because Musk exercised control over the Grant, the entire fairness standard of review applied; (ii) because the defendants (Musk, plus the directors who took part in the Grant decision) did not show that (a) the Grant was approved by a committee of independent directors or (b) the Grant was approved by an informed vote of the majority of the minority stockholders, the defendants retained the burden of proving that the Grant was entirely fair; and (iii) the defendants failed to prove that the Grant was “entirely fair.”

The 200-page Opinion spurred an immediate public response from Mr. Musk, who has since contemplated reincorporating Tesla outside of Delaware.² It has also captured the attention of executives and boards across the country, eager to understand the impact of this decision on Delaware law and on their own actions. The particular facts the Court found are unlikely to be found in many other public companies. Musk—whom the Chancellor called the paradigmatic “Superstar CEO”—is in many ways unique. This is, in fact, not the first time that Chancellor McCormick has had reason to assess Musk’s outsized influence at Tesla. Eighteen months ago, in the throes of Musk’s legal fight over his commitment to purchase Twitter, Inc., the Chancellor found compelling Musk’s argument that, despite Tesla’s written policies stating that all employees’ emails would be monitored, Tesla also had unwritten “Musk-specific rules” under which no one would have dared monitor Musk’s emails without his permission. As we wrote at the time, in Twitter v. Musk, this influence helped save Musk. While an officer’s or director’s use of another entity’s email system for privileged communications typically results in waiver of privilege, because Musk possessed unique powers at Tesla, in his case no waiver was found. Chancellor McCormick noted then that “[o]ne can debate whether this corporate reality makes for good ‘corporate hygiene,’ but it is difficult to discredit the recitation of the facts.”³ It appears that the chickens that saved Musk in Twitter v. Musk have now come home to roost. But it is unlikely that we will ever again see a set of facts quite like those here, where the Chancellor found the “avalanche of evidence” on what she termed Musk’s “managerial supremacy . . . equaling or even exceeding the imperial CEOs of the 1960s” to be “so overwhelming that it is burdensome [for the Court] to set out in prose.”⁴

Nevertheless, the case is highly instructive for the factors the Court identifies, and the Opinion’s holdings and lessons are critical for boards of directors, compensation consultants, executive compensation counsel, and the companies they serve to understand. In this article, we seek to go beyond the “news coverage” on the Opinion, providing a detailed overview of the Court’s key holdings and reasoning, and conclude with takeaways that should now be considered when contemplating compensation arrangements or other transactions with potentially conflicted controllers.

Entire Fairness Standard Applied (Musk Exercised Transaction-Specific Control)

The Court first analyzed whether Musk exercised control over the Grant process. The Court found that he did, thereby subjecting him to the fiduciary duties of a controlling stockholder and causing the transaction to be reviewed under the heightened entire fairness standard. Because Musk did not hold a mathematical majority of Tesla’s voting power (he held approximately 21.9%), the Court focused on whether Musk controlled the transaction (i.e., the Grant process) as opposed to whether Musk controlled the company generally.⁵

Aside from his stock ownership, the Court viewed the following as supportive of its finding of transaction-specific control:

• Musk’s boardroom and managerial supremacy, i.e., his “CEO superstardom;”⁶
• Musk’s personal relationships with several members of the Board and the Compensation Committee;
• The significant investment by two of the directors in other Musk-controlled entities;
• The significance of the value received by the directors through their compensation for serving on the Board⁷; and
• Musk’s domination of the Grant process and the seeming lack of meaningful negotiation between the Compensation Committee and Musk.

Defendants Retained Burden of Proof (Deficient Board and Stockholder Approvals)

Having decided that the entire fairness standard applied to the Grant due to Musk’s control over the Grant process, the Court next analyzed whether the defendants were able to shift the burden of proof to the plaintiff. The Court decided that the defendants retained the burden of proof. Under Delaware law, “the defendants may shift the burden of persuasion by one of two means: first, they may show that the transaction was approved by a well-functioning committee of independent directors; or second, they may show that the transaction was approved by an informed vote of a majority of the minority shareholders.”⁸ For the reasons described above, the Court found that there was no well-functioning committee of independent directors in respect of the Grant process.⁹

The Court then turned to whether the stockholder vote was fully informed and found that it was not. When the Board approved the Grant, it directed that the Grant be submitted for stockholder approval¹⁰ by a majority of the votes cast, excluding shares beneficially owned by Musk and his brother. Tesla filed its definitive proxy statement relating to the Grant (the “proxy statement”) with the Securities and Exchange Commission on February 8, 2018. The Grant was approved by 73% of the votes cast, excluding shares beneficially owned by Musk and his brother and notwithstanding the opposition of Glass Lewis and Institutional Shareholder Services.¹¹ Nevertheless, the Court found that two key deficiencies in the proxy statement rendered the vote not fully informed (i.e., the stockholders were not apprised of all material information related to the Grant¹²).

First, the proxy statement did not disclose any of the factors that led the Court to conclude that the Compensation Committee was not independent with respect to Musk. Rather, the proxy statement explicitly and frequently described the members of the Board, and the Compensation Committee, as independent.¹³

Second, the proxy statement failed to include material information concerning the process that resulted in the Grant. As the Chancellor wrote, “when fiduciaries choose to provide the history of a transaction, they have an obligation to provide shareholders with ‘an accurate, full, and fair characterization of those historic events.’”¹⁴ She identified material omissions including:

• Musk’s control over the Grant process, as evidenced by the timing, lack of meaningful negotiation over the size or other terms of the Grant, and absence of a benchmarking analysis; and
• A description of the initial conversation between Musk and Compensation Committee Chairman Ehrenpreis, during which Musk established the key terms of the Grant, even though such description appeared in at least four drafts of the proxy statement before being removed from the final proxy statement.¹⁵

Notwithstanding the above, the defendants argued that the stockholder vote was fully informed because the economic terms were correctly disclosed. The Court rejected this argument, holding that no case in Delaware supported the position and stating that “materiality extends beyond economics to information regarding process, conflicts, incentives, and more.”¹⁶

Grant Was Not Entirely Fair (Flawed Process and Unfair Price)

The Court then proceeded with its entire fairness review of the Grant. Referring to another recent lawsuit involving Musk and Tesla (In re Tesla Motors, Inc. Stockholder Litigation), the Court presented the entire fairness standard as follows:

“The concept of fairness has two basic aspects: fair dealing and fair price. The former embraces questions of when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were obtained. The latter aspect of fairness relates to the economic and financial considerations of the [transaction] . . . However, the test for fairness is not a bifurcated one as between fair dealing and price. All aspects of the issue must be examined as a whole since the question is one of entire fairness . . . As a result, ‘a fair process usually results in a fair price’ . . . [but] [t]he opposite is also true: ‘an unfair process can infect the price.’”¹⁷

Fair Dealing

Looking to many of the same facts already presented in connection with the control and stockholder vote analyses, the Court found that the defendants failed to demonstrate that the Grant process was fair. Mapped onto the Weinberger factors, the Court emphasized the following facts:

• Although Musk did not initiate the process (Ehrenpreis did), he controlled the remainder of the timeline by unilaterally and repeatedly extending or accelerating deadlines. As a result, the Board’s work on the Grant occurred in small bursts and under pressure, making it difficult to meaningfully evaluate the Grant and interface with Musk. Therefore, the Chancellor downplayed the significance of the process taking many months overall.
• The Court found that there were no meaningful (“adversarial”¹⁸) negotiations between the Board and Musk, regardless of the fact that the terms of Musk’s initial proposal changed over time, and regardless of the fact that some of the final terms were ultimately more favorable to the stockholders.¹⁹The Court also found that the independent compensation consultant played no role in any negotiations, nor did it engage in benchmarking.
• As discussed above, the Court found that the Board and stockholder approvals were flawed. Approval by the Board was tainted with conflicts and Musk’s dominance, and approval by the stockholders was secured through the use of a deficient proxy statement.

Fair Price

The Court began its analysis of fair price by stating: “There is no absolute limit on the magnitude of a compensation grant that could be considered fair. But ‘[p]rocess can infect price.’ And ‘where the pricing terms of a transaction that is the product of an unfair process cannot be justified by reference to reliable markets or by comparison to substantial and dependable precedent transactions, the burden of persuading the court of the fairness of the terms will be exceptionally difficult.”²⁰ The Court rejected a series of arguments that emphasized the economic reality of the Grant:

• The “get” (a committed CEO) outweighed the “give” (the Grant). The Court countered that:
  • Musk did not actually have to maintain his position as Chief Executive Officer under the Grant.
  • Musk already owned a sizeable equity stake in Tesla, such that he should have been sufficiently incentivized to further the interests of the company without the Grant.
  • Musk’s public statements during the Grant negotiation process undermined his need for an incentive to remain at Tesla or further its interests.²¹
  • The size was essentially calibrated to help Musk fund priorities unrelated to Tesla.
• The Grant was designed to maintain Musk’s attention compared to other businesses like SpaceX and incentivize transformative growth of Tesla. However, the Court emphasized: (i) that the terms of the Grant did not require Musk to limit his outside activities; and (ii) the milestones were not ambitious based on then-current internal projections. For example, the Board deemed achievement of certain milestones to be 70% likely shortly after the Grant was approved.²² Moreover, Tesla ultimately achieved the first three milestones (in line with its internal projections) by September 30, 2020.²³
• The Grant was “only upside” to stockholders and would provide meaningful and sustained growth. In response, the Court highlighted flaws in the terms of the Grant, including: (i) revenue milestones not being dependent on profitability; (ii) the lack of protections for falling below previously met achievement thresholds; and (iii) no restriction on Musk’s ability to sell his existing equity stake.
• When compared to private equity compensation, the Grant price was fair. However, the Court did not consider this relevant because Tesla was a public company.
• The stockholders ultimately benefited from the Grant. However, the Court found that the defendants failed to prove Musk’s efforts directly caused the recent growth or success of Tesla.

The Remedy: Rescinding the $55.8 Billion Grant

In conclusion, the Court ordered that the Grant be rescinded in full. The Chancellor stated: “This Grant is not ‘too complex to unscramble[.]’ Rescission is uniquely available: no third-party interests are implicated, the entire Grant sits unexercised and undisturbed, and exercised shares would be subject to [a five-year hold period].”²⁴

Takeaways

As boards of directors, compensation consultants, executive compensation counsel, and the companies they serve await further guidance from a likely appeal, below are several key takeaways to keep in mind when setting compensation for executives, particularly those who are deemed (or may be deemed) to control the company or any particular transaction (including their compensation-setting process):

1. Always consider whether the executive is a controlling stockholder – not just of the company, but of any particular transaction. Boards should take a holistic approach to this analysis, accounting for both general and transaction-specific control. A finding of either would be sufficient to establish that the executive is a controller. General control focuses on equity ownership, director designation rights, enhanced power pursuant to governing documents, and outsized influence through high status roles like Chief Executive Officer, Chairman or founder. Transaction-specific control focuses on the executive’s relationships—personal or financial—with key decision makers on the board with respect to the transaction at issue. If an executive is determined to be a controller, boards must acknowledge that the entire fairness standard of review will apply, and their procedures must be directed toward satisfying that standard. The determination of whether an executive is a controller will be made in hindsight by a court, and there are no bright line standards for such a determination, which may lead boards in some circumstances to expand an “entire fairness” approach to more borderline cases.

   For tips on designing and executing an effective deal process in conflicted transactions, see Baker Botts’s article linked HERE.

    

2. Consider the following factors when determining the independence of key decision makers on the board, in particular, the compensation committee:
   1. Personal and professional relationships with the executive, including time spent together in non-business settings, and the executive’s influence on the decision maker’s career.
   2. Financial relationships with the executive, including investments in other business ventures of the executive.
   3. Whether the compensation received from serving as a director (i) is outsized compared to ordinary, market-rate compensation, (ii) constitutes a large portion of such director’s wealth or (iii) is “life-changing,” thereby rendering such director beholden to a controller of the company.²⁵

   Furthermore, boards should continue to analyze the independence of external advisors, e.g., compensation consultants, in furtherance of producing a fair process.

    

3. In an effort to minimize an executive’s control over the negotiation process, and to support a fair negotiation process, boards, compensation committees and executives should consider taking the following actions in situations where the executive may be a controlling stockholder (even if not aligned with current market practice):
   
   
   1. Initiating the compensation negotiation process.
   2. Setting the initial terms of the executive’s compensation.
   3. Maintaining control of the timeline for negotiations and ensuring directors have adequate time to review and consider relevant materials.
   4. Encouraging the executive to engage his/her own advisor during negotiations to avoid other officers unwittingly becoming the executive’s advocate.
   5. Engaging in meaningful arms-length negotiations regarding the size and terms of compensation and enhancing the level of detail in board or committee minutes describing those discussions and negotiations.
      
      


4. Remember the following if approval of executive compensation is subjected to a binding stockholder vote, whether by choice or obligation:
   
   
   1. Ensure the company’s proxy disclosure is accurate and complete in all material respects, spanning from commencement of negotiations through approval, and including a description of actual or potential conflicts between the executive and key decision makers on the board.²⁶ When transacting with a controlling stockholder, an analogous level of detail may be found in a typical “Background of the Merger” section in a merger proxy statement.
   2. Approval of the economic terms of the executive’s compensation, alone, does not render a stockholder vote to be fully informed.
      
      

5. Benchmarking is pivotal evidence of fair dealing. In response to the defendants’ argument that traditional benchmarking is not available if companies, executives, and plans are not comparable, the Court stated “That is a hard sell. As CEO Musk’s job was the same as every other public company CEO: Improve earnings and create value.”²⁷

    

6. Success of prior compensation plans may not be supportive of the terms of or growth in future compensation plans. Although the Court presented a history of Musk’s prior compensation plans and discussed the achievements thereunder, the Court did not look to such achievements as supportive of the defendants’ position under the entire fairness standard. Rather, the prior awards were used for comparative purposes to show the outsized nature of the Grant compared to Musk’s historical compensation. Note, also, that the Court rejected the defendants’ hindsight argument that the Grant was fairly priced “because it worked,”²⁸ i.e., the milestones were achieved.

    

7. Boards may now wrestle with “how much is too much” when contemplating equity compensation and alignment of executive interests with stockholders. The Chancellor considered the value of Musk’s existing ownership stake in Tesla (both in terms of percentage ownership and dollar value of that stake) as providing him a sufficient incentive to forego compensation.²⁹ She did not address the distinction between an executive’s receiving a return on capital (ownership stake) and receiving compensation for labor, an important distinction. In the vast majority of executive compensation decisions, wealth accumulation in company stock is simply not considered. The Court’s emphasis throughout the Opinion on the sheer unprecedented size of the Grant (starting with the first paragraph on the first page³⁰) suggests its importance in the Court’s analysis. As most executives will have nowhere near the ownership interest or stockholding value of an Elon Musk or possibly other Superstar CEOs, it would seem that the decision should not restrain boards from approving compensation grants under the business judgment rule in most circumstances, particularly when compensation benchmarking is utilized. Nevertheless, in a situation with a potential controller, boards should take into consideration the executive’s existing ownership stake when evaluating the incentive effect of the compensation.

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