United States: Delaware Court Applies Traditional Entire Fairness Standard To Very Large Stockholder-Approved, Performance-Based Equity Award

In Short

The Case: A Tesla stockholder sued Tesla's board of directors to rescind a performance-based stock option grant awarded to Elon Musk, Tesla's CEO. The option award was worth a total of $56 billion and offered the opportunity to secure 12 tranches of options, each representing 1% of Tesla's outstanding shares as of the date when the board approved the award.

The Result: The Delaware Court of Chancery applied the "entire fairness" standard to the board's decision to make the option award, on the ground that Musk controlled Tesla with respect to this transaction and the Tesla directors were conflicted, and even though the award was conditioned on approval by a majority of Tesla's disinterested stockholders, which was obtained. Following a trial, the court invalidated the award.

Looking Ahead: Courts will apply the traditional entire fairness standard to transactions with controlling stockholders, and place the burden of proof on the defendants even if a majority of the minority stockholders approve the transaction at issue, when the stockholder vote is not "fully informed." In the context of an equity award, the company should make sure that it fully describes to stockholders the process that leads up to the award and the relationships between the award recipient and the directors.

The Delaware Court of Chancery recently invalidated the equity compensation plan awarded to Elon Musk, the CEO and "Technoking" of Tesla. Tornetta v. Musk, — A.3d —, 2024 WL 343699 (Del. Ch. Jan. 30, 2024).

The option award was, in the court's words, "250 times larger than the contemporaneous median peer compensation plan and over 33 times larger than the plan's closest comparison, which was Musk's prior compensation plan." The plan gave Musk the opportunity to obtain 12 tranches of options, each of which represented 1% of Tesla's shares outstanding as of January 2018.

For each option tranche to vest, Tesla had to achieve both a market capitalization milestone and an "operational" milestone. The 12 market capitalization milestones increased in $50 billion increments, beginning at $100 billion and ending at $650 billion. For Musk to achieve an operational milestone, Tesla had to hit a revenue or EBITDA target in four consecutive quarters. There were 16 operational milestones, eight corresponding to revenue growth and eight to EBITDA growth. Musk could pair any one of these 16 operational milestones with the relevant market capitalization milestone: therefore, to obtain all the shares available under the plan, Musk needed to increase Tesla's market capitalization to $650 billion, but was only required to hit four of the eight EBITDA milestones (so long as he hit the eight revenue milestones). If he achieved all of the milestones, Musk's potential stake in Tesla would increase from around 22% to around 28%. The award was the largest potential compensation opportunity ever observed in the public markets.

The Tesla board and compensation committee discussed the grant intermittently with Musk between June 2017 and January 2018. By January 2018, the terms of the option award were settled, and the company submitted it for stockholder approval at a special meeting of stockholders held on March 21, 2018. The board had conditioned the option award on a vote of a majority of the disinterested stockholders. At the special meeting, 73% of the votes cast (excluding those cast by Musk and his brother) were in favor of the option award.

In June 2018, a stockholder sued to rescind the grant in the Delaware Court of Chancery. The stockholder alleged that Musk and the other directors had violated their fiduciary duties to Tesla and committed corporate waste, and that Musk had been unjustly enriched. The court denied the defendants' motion to dismiss and subsequently denied cross-motions for summary judgment. The court held trial in November 2022 and argument and post-trial briefing were completed by April 2023.

On January 30, 2024, the court issued a 200-page post-trial opinion rescinding the option award. The court ruled that, so far as the option award was concerned, Musk controlled Tesla, even though he only owned 22% of the company's stock. This was because of his status as a "Superstar" CEO, his "thick" relationships with many board members, and his influence over the process that led to the grant. The court found that Musk dictated the timing of the process that led to the option award, and that there was little negotiation over the terms of the grant. In the court's words, the members of the compensation committee viewed the option award process not as an "arm's length negotiation" but a "form of collaboration with Musk." Moreover, approval of the award was not informed by traditional benchmarking studies, even though "the extraordinary nature of the Grant should have made benchmarking more critical, not less."

Because Musk controlled Tesla with respect to the option award, the court applied the entire fairness standard. The court then ruled that Musk and the defendant directors bore the burden of proving the award was fair to the stockholders. If the disinterested stockholders had approved the grant in a fully informed vote, the burden would have shifted to the plaintiff—but the vote was not fully informed. In particular, the court found that the special meeting proxy statement had wrongly described the members of the compensation committee as independent, and had failed to describe the deficiencies in the process that led up to the award. The court also rejected the argument that the proxy statement needed to disclose only the key economic terms of the grant. The court then held that the price, as well as the process that led to the grant, was unfair: among other things, there was no evidence that Tesla needed to make such a big award to obtain the benefits of Musk's services, and some of the milestones were, in the court's view, in fact relatively easy to achieve.

After ruling that the defendants had failed to show that the award was fair to Tesla, the court ordered that it be rescinded.

Three Key Takeaways

1. A stockholder who has only a modest equity stake—here, 22%—may be deemed a controller. The importance of the CEO to the company, and the CEO's "star power," may be relevant to determining controller status.
2. When making executive compensation awards, the company should undertake a non-rushed, arm's length, deliberative process, and carefully document it. The company should then make sure to fully disclose all material information concerning the award, and not just the economic terms, if it wishes to obtain the benefits of a stockholder vote.
3. Determinations of director independence under stock exchange and securities laws do not necessarily protect directors from being found to have conflicts of interests. The court's determination that Musk controlled Tesla regarding this transaction was based in part on its findings that a majority of the directors were not independent from him.