The Delaware Chancery Court rejected an attempt by Tesla’s Board of Directors to dismiss a challenge to CEO Elon Musk’s “extraordinary” 2018 compensation package.1 Because Musk is also Tesla’s controlling stockholder, the Court ruled that his compensation package is subject to the entire fairness standard of review. The Court also ruled that business judgment deference was available under the MFW2 roadmap, but was not obtained in this case. Although one prong of the MFW framework was satisfied—approval by a majority of the disinterested shares—and shifted the burden of proof to the plaintiff, the other prong was not satisfied—approval by the Tesla Board of Directors was ineffective because Musk was presumed to dominate the Board. With the presumptions necessarily accorded to the plaintiff at the motion to dismiss stage, the Court ruled that the plaintiff “just barely” satisfied his burden to show it is reasonably conceivable that Musk’s compensation package is unfair to Tesla.
In 2018 the Board of Tesla, Inc. (NASDAQ: TSLA) crafted a compensation package for Elon Musk, Tesla’s then-chairman, CEO and largest stockholder, involving stock options with a potential value upwards of $55.8 billion, assuming all performance hurdles would be met.3 The award was negotiated by Tesla’s Compensation Committee (which the Tesla board had determined was composed entirely of independent directors for NASDAQ listing purposes), with advice from outside counsel and compensation consultants, and was conditioned on the approval of a majority of disinterested shares voting at a special meeting of Tesla stockholders. At the special meeting, 73% of the disinterested shares present voted in favor of the award.4
Plaintiff sued Tesla and the individual directors, asserting, among other things, direct and derivative claims for breach of fiduciary duty in approving the compensation package. Plaintiff urged the Court to apply the entire fairness standard, under which Tesla’s Board would bear the burden of proving that both the amount of the award and the process used to craft it were “entirely fair” to the company’s stockholders. Defendants maintained that the Court should apply the business judgment rule, a more lenient standard with more deference to the Board, because a majority of the disinterested shares had ratified the award. The Court of Chancery of Delaware, in an unpublished decision, denied in part defendants’ motion to dismiss plaintiff’s claims.
For purposes of the motion to dismiss, the Court accepted that Musk is a controlling stockholder.5 Accordingly, the Court ruled that entire fairness was the appropriate standard as an initial matter.6
The Court refused to distinguish approval of a compensation award for a controlling stockholder from company-transformational transactions (those like mergers that require both board and stockholder approval under Delaware law) involving a controlling stockholder. Therefore, the Court ruled that the MFW framework was applicable.7 The Court explained that MFW’s “dual protections” (i.e., approval by a fully-functioning special committee and an informed, uncoerced majority of the disinterested shares) can “‘neutralize’ the conflicted controller’s ‘presumptively coercive influence’ so that judicial second-guessing is no longer required.”
The special-committee prong of MFW was presumptively not satisfied in this case because, for purposes of the motion to dismiss, the Court had accepted that the Tesla Board is dominated by Musk. This presumption applied even though the Tesla Board had determined that a majority of its directors are independent for NASDAQ listing purposes. The test for independence for this purpose under Delaware law is whether the directors are independent of the controlling stockholder’s influence.
With respect to the disinterested-stockholder-vote prong of MFW, the Court ruled that the applicable voting standard depends on the voting standard that would otherwise apply under Delaware law. The transaction at issue in MFW was a merger so the voting standard for a merger applied—a majority of the outstanding voting shares. However, the Musk award was not a transaction for which there is a specific voting standard under Delaware law so the general voting standard was applicable—a majority of the voting shares present at a meeting for which there is a quorum.8 Under that standard, the Court held that this prong of MFW was satisfied in this case.9
The MFW roadmap requires satisfaction of two prongs to shift to business judgement review but only one prong to shift the burden to the plaintiff. With one prong of MFW satisfied in this case, the burden shifted to plaintiff to show it was reasonably conceivable that Musk’s compensation package is unfair to Tesla.
The Court ruled that plaintiff met this burden, despite noting that there were many factors that would point to the award being rational, both in terms of process and cost.10 Given the stage of this case, when a court must give deference to a plaintiff’s version of the facts, the Court concluded plaintiff had “cleared the bar” to survive a motion to dismiss, “albeit just barely.”11
Although the case speaks to those relatively rare situations when an executive is also a controlling stockholder, it is nonetheless significant. It serves as a reminder that any transaction involving a conflicted controlling stockholder, even awarding executive compensation, may be subject to entire fairness review and that independence for stock exchange purposes is not necessarily independence for Delaware law purposes. The case also extends the MFW framework beyond non-transformational transactions and explains which stockholder ratification standard is applicable in such transactions. Armed with this information, well-advised boards can follow the roadmap to business judgment review and deter stockholder litigation.