THE CASE AGAINST ELON
In 2023, Richard Tornetta a Tesla stockholder, sued Elon Musk and the directors of Tesla for a breach of fiduciary duty. The object of the case was a compensation plan approved for Elon in 2018.
The compensation plan offered Elon the opportunity to secure 12 total tranches of options, each representing 1% of Tesla’s total outstanding shares as of January 21, 2018.
Ordinarily, a board’s decision to determine the pay of a CEO, would not be subject to judicial scrutiny. However, Delaware law, recognizes “CONFLICTED CONTROLLER TRANSACTIONS” between companies and their controlling stockholders and grants the court the power to review such transactions, under the “entire fairness standard” (to be discussed below). [1] In Delaware, where a “conflicted controller transaction” is established, the defendant must prove that the disputed transaction was entirely fair and was approved by a fully informed vote of majority stockholders.
DELAWARE’S FAIRNESS STANDARD
Delaware law sets out a two-pronged test for plaintiffs to prove the fairness of a conflicted-controller transaction: PROCESS AND PRICE. [2]
- PROCESS
In Delaware, to determine a breach of fiduciary duty, the law requires an examination of the conduct of directors throughout the transaction and processes leading to its conclusion.[3] The courts examine key managers or advisors who play a critical role in presenting options, providing information, and making recommendations.
In the present case, Elon’s relationship with Tesla’s directors and members of the compensation committee were scrutinized. The court assessed the fact that, Tesla’s legal representative was also Elon’s former divorce lawyer. The court furthered assessed the fact that the chair of the compensation committee had a 15-year personal relationship with Elon and his brother. In addition, certain board members had long standing business and personal relationships with Elon and have vacationed regularly. Some board members even admitted in their depositions that substantial portions of their wealth were directly or indirectly from Elon.
In addition to the relationships, the court also examined the pace of the process, the nature in which major decisions around the compensation package were made and the size and terms of the compensation.
The court stated, in assessing the above factors, held that all these factors indicated that the directors were less intent on negotiating and more interested in achieving the result that the controller wanted.
2. PRICE
The second leg of determining the fairness of a conflicted-controller transaction is the price. In determining fairness of price, the focus is on economic and financial considerations of the transaction such as assets, market value, earnings, future prospects which affect the intrinsic or inherent value of a company’s stock.[4] Being a conjunctive test, a determination of fair process often leads to fair price and vice versa, since the test emphasizes entire fairness.[5]
The defendants argued that Tesla’s benefit outweighed Elon’s, therefore, the compensation was fair as a whole. Additionally, the price was set high to secure Elon’s commitment to Tesla because he had hinted at leaving.
The court held however that Elon had consistently shown in his actions that he was not going to abandon Tesla. Since Elon owned 21.9% of Tesla shares it was more than enough incentive for him to drive the growth of and commitment to Tesla. Further, if the price was solely to secure his commitment, additional terms such a “minimum working hours requirement” with Tesla could have achieved the same aim.
SHIFTING OF BURDEN ON DEFENDANTS
Once a plaintiff successfully proves that the fairness test is applicable, the burden shifts to the defendant to prove fairness of the transaction, to avoid judgement against themselves.[6] Defendants must show that either the transaction was approved by a well-functioning committee of independent directors or the transaction was approved by an informed vote of a majority of the minority shareholders.
In Delaware, a director’s conflict or potential conflict with a transactional counterparty is material information that must be disclosed.[7] Stockholders are not obliged to conduct extensive due diligence on received information before votes, because they rely on the accuracy of the information from the board.
In the given case, the court opined that the actual and potential conflicts tesla directors and members of the compensation committee had with Elon were not adequately disclosed. In addition, they failed to make certain disclosures that were material to the transaction.
THE COURTS DECISION
The court granted the plaintiff’s only relief, a rescission of the 2018 compensation plan. The court found that the despite 70% of shareholder approval, the defendants failed to meet the fairness standard described above. [8][9]
In finding against Elon, the judge held that the plaintiff had proved Elon had “transaction-specific” control due to his significant shareholding (21.9%) in Tesla, that he had exercised direct control over the directors and the specific transaction, that he had personal relationships with the directors, had extensive hiring power and had supremacy over the board and management in daily operations.[10]
In addition, it was held that the stockholder vote, approving the compensation, was not fully informed because the proxy statement dishonestly described the directors as independent and misleadingly omitted details about the process leading to the determination of the compensation.
RELEVANCE OF THE DECISION TO TECHNOLOGY COMPANIES IN DELAWARE
After the court’s decision, Elon tweeted “Never incorporate your company in the state of Delaware.” With nearly 1.4 million legal entities incorporated in Delaware (including over two-thirds of Fortune 500 companies), and approximately 80 percent of U.S.-based initial public offerings choosing the state as their corporate home, it has become imperative to assess what the relevance of this decision is for directors, stockholders and potential investors of technology companies in Delaware? Is Elon right in his tweet advising against incorporation in Delaware? The author believes that the simple answer is NO. Here is why.
Admittedly, the judge barely hid her disdain for Elon as a person, an opinion many may share but his likability was not what was under examination.
Directors play a crucial role in managing companies and are obliged to act in the interest of the company and stockholders. Conversely, the decision of the stockholders of a company is one that must be sacred. The “owners of the company” should have confidence in the finality of their decision.
Presumably, the peculiar nature of how many successful technology companies are run necessitated the introduction of “conflicted controller transactions” with controlling stockholders. There is however a clear limitation on the circumstances the court is allowed to interfere with the decision of stockholders and thus judicial deference still applies in most transactions in Delaware.
The fiduciary duty of directors and the will of shareholders are coterminous and conjunctive: the duty does not trump the will. However, since stockholders’ approvals rely on the recommendations of directors, it is imperative that they are accurate and fully disclose all potential and actual conflicts. This informs the stockholders’ decision, and its validity cannot be questioned subsequently.
Objectively, rescission of the agreement was also far reaching since the court could have adopted an equitable modification of the terms or rescissory damages for Tesla, since the milestones were in fact achieved by Elon.
What is rather interestingly lacking in the judgement was the absence of penalties levied against the directors for the breach, which perhaps supports the view of the judge’s seeming preoccupation with Elon in the matter. Delaware provides direct damages against such defendant-directors.[11]
The decision therefore affords stockholders further precedent to bring actions when a breach of fiduciary duty occurs and is discovered later. It was not a departure from the laws of Delaware neither does it diminish the power of shareholders or stockholders per se. Judicial activism in light of blatant disregard for process is in the writer’s opinion warranted.
Rather than being concerned, technology corporations in Delaware should therefore strive to implement and exercise best corporate governance practices, in line with the provision of the DGCL and relevant state laws. The sovereignty of shareholders are not impacted significantly by this decision.
About the Author
Vanessa Kofinti is a lawyer in Ghana who focuses on corporate governance and compliance in the technology law space. She has an experience working with fintechs and is passionate about the convergence of law and policy, to drive the growth of technology law in Ghana and Africa.
[1] Tornetta v Musk C.A. No. 2018-0408-KSJM (Del Ch 2023) at 1
[2] Ams. Mining Corp., 51 A.3d at 1239
[3] Chen v. Howard-Anderson, 87 A.3d 648, 666 (Del. Ch. 2014)
[4] Weinberger v. UOP, Inc. 457 A.2d at 711
[5] Id. 702
[6] Tornetta v Musk C.A. No. 2018-0408-KSJM (Del Ch 2023) at
[7] In re Orchard Enters., Inc. S’holder Litig., 88 A.3d 1, 22 (Del. Ch. 2014), Millenco L.P. v. meVC Draper Fisher Jurvetson Fund I, Inc., 824 A.2d 11, 15–19 (Del. Ch. 2002)
[8] Id. At 8
[9] Tornetta v. Musk, 250 A.3d 793, 805 (Del. Ch. 2019) at 98
[10] See section 203(c)(4) Delaware General Corporation Law (the DGCL), Tornetta v Musk C.A. No. 2018-0408-KSJM (Del Ch 2023) pp 108- 122
[11] In re Dole Food Co. Inc. Stockholder Litigation C.A. No. 8703-VCL
