Musk Case Lays Blueprint for Companies to Safeguard Executive Pay

The blockbuster decision rescinding Elon Musk’s nearly $56 billion compensation plan at Tesla Inc. relates to an extraordinary amount of consideration paid to a superstar, billionaire CEO. But the case also offers important lessons for boards and compensation committees beyond the specific context.

In Tornetta v. Musk, the Delaware Court of Chancery issued a post-trial decision Jan. 30 ruling that the directors of Tesla breached their fiduciary duties when, in 2018, they adopted a $55.8 billion 10-year equity-based compensation plan for Musk, Tesla’s CEO. The plan was 250 times larger than the contemporaneous median peer compensation plan and over 33 times larger than the plan’s closest comparison (Musk’s prior compensation plan).

By 2021, Tesla had achieved all of the plan’s milestone targets and Musk had been granted all the options. Chancellor Kathaleen St. Jude McCormick ordered rescission of the entire plan, eliminating all the compensation Musk had earned.

Process Is Key

The court found Musk was a controller of Tesla (at least with respect to the compensation plan) and therefore that “entire fairness”—Delaware’s most exacting standard of review—applied to the court’s review of his compensation plan. Under this standard, the plan had to be fair to the corporation and its minority stockholders both as to price and process.

Although the plan was approved by a majority of the minority stockholders, there was no shift of the burden of proof to the plaintiff to establish unfairness of the plan, as the court found that the proxy disclosure was materially flawed, which rendered the stockholder vote not “fully informed.” Therefore, the burden of proof remained with the defendants to prove fairness.

We would note that, if either the plan (a) had been approved by a committee of independent directors, or (b) the disclosure to stockholders had been adequate, and the defendants would not have had the heavy burden of proving fairness of “the largest compensation plan in the history of public markets.” And if both (a) and (b) had been satisfied, the business judgment rule would have applied, requiring judicial deference to the board’s decision (absent waste).

Accordingly, boards and board committees should keep in mind that their process determines the judicial standard of review, and the standard of review can be outcome-determinative.

Directors’ Independence

In the court’s view, there was no approval of the compensation plan by anyone independent of Musk. The court found that the purportedly independent Compensation Committee members had strong business and personal ties to Musk such that they were “beholden” to him. That conclusion was reinforced, the court said, by the directors acting with a “controlled mindset,” based on their testimony that they viewed their role as providing Musk with compensation that would be “fair to him” and make him “happy.”

The decision highlights there’s a clear benefit to having at least one clearly independent director to avoid this kind of result. And continuing review of directors’ independence as to a particular individual or issue is critical, as, for example, a compensation committee may be independent with respect to compensation generally but not for a particular executive.

Compensation Committees

The court viewed Tesla’s Compensation Committee as having failed to ask the critical question whether this extraordinary amount of compensation was necessary to achieve the board’s objectives of retaining and incentivizing Musk. The court found the committee hadn’t engaged “at all” in negotiations with Musk to determine if a lesser amount would have sufficed. Most interestingly, the court said Musk already was well-compensated for his efforts at Tesla through his pre-existing 21.9% stake in the company, the value of which would increase as a result of his efforts.

Accordingly, compensation committees should engage in an active, “adversarial” (the court’s word) negotiation process with an executive to set compensation—and should maintain a record of those efforts.

The decision makes clear that, even in the context of a superstar CEO or controller-CEO, the committee should make “asks”—as, even if the answer will be “no,” the asks may change the negotiating dynamics. In addition, based on Tornetta, compensation committees should consider the extent to which an executive’s pre-existing equity stake may already provide incentive to the executive.

Rescission Remedy

The court held that nothing in the record provided a basis for it to order rescission only to the extent the compensation plan was unfair. Accordingly, in litigation over a compensation plan, defendants should consider, in addition to addressing the fairness of the plan or grant overall, seeking to reduce the risk of a remedy requiring disgorgement of the entire amount by identifying that portion that is most defensible.

Controller Status

The court found that Musk was a controller of Tesla, at least with respect to the compensation plan. It noted a constellation of factors, including his 21.9% equity stake in the company.

The court referenced the mathematical analysis in its 2020 Voigt v. Metcalf decision, which illustrated that, given that not all stockholders vote, minority stockholders with less-than-majority stakes have a more meaningful advantage than may initially be evident.

For example, if a 21.9% stockholder favors a particular outcome, the holder will “win” as long as holders of approximately one-in-three shares vote the same way, whereas an opponent would have to garner about 71% of the other shares to win. Not only does such a stake provide a meaningful “leg up” on voting, the court stated in Tornetta, but at a minimum it “supplies a powerful rhetorical calling card to play in the boardroom.”

The court’s discussion may signal increased openness to finding control status of less-than-majority stockholders, when there are other features suggesting control.

Emails and Jokes

It can’t be emphasized enough that emails, although informal communications, should be drafted with the same care as formal corporate communications. Notably, the 201-page Tornetta opinion contains 939 footnotes, many of which quote from internal emails of Tesla directors and executives to support or refute the plaintiff’s claims.

In addition, we would suggest jokes should be avoided in the context of serious corporate matters. As one example in this case, Musk testified that his giving himself the title “Technoking,” which he compared to “being a monarch,” was “intended as a joke.” The court, crediting that testimony, decided to not take the comment into account in its control analysis—but the court stated that “organizational structures, including titles, promote accountability by clarifying responsibilities. They are not a joke.”

Observations

The opinion suggests judicial skepticism as to the unique value of a superstar CEO to justify this level of compensation. We would emphasize, however, that the plan at issue essentially offered Musk the opportunity to obtain an additional 6% equity interest in exchange for $600 billion of growth in stockholder value. The company had a market capitalization of $55 billion when the plan was adopted. Thus, $600 billion reflected growing the company’s market capitalization about thirteen-fold.

We would expect that many companies would gladly take the 6%-for-$600 billion deal. Indeed, Tesla is one of less than a handful of companies that from 2018 to 2022 achieved thirteen-times growth in their market capitalization. The decision highlights the benefits of a process that permits the court to defer to the business judgment of independent directors.

The case is Tornetta v. Musk, Del. Ch., No. 2018-0408, 1/30/24.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Gail Weinstein is senior counsel in Fried Frank’s M&A and private equity practice.

Philip Richter is partner and co-head of Fried Frank’s mergers and acquisitions practice.

Steven Epstein is partner and co-head of Fried Frank’s mergers & acquisitions practice.

Write for Us: Author Guidelines