Dear Clients and Friends,
We wish to highlight for you a major legal development in Delaware corporate case law. The Delaware Chancery Court ruled that a $55B compensation package awarded to Elon Musk, CEO (and at that time also Chairman) of Tesla, Inc., as well as a major shareholder of Tesla, should be rescinded after the court ruled that the approval process of such award was “deeply flawed”.
As the Israeli courts tend to follow the Delaware case law and will always look to the Delaware courts for comparative corporate law review, it is very likely that this ruling will have an impact on Israeli corporate case law relating to dealing with controlling shareholders, other significant shareholders, and executive compensation of dominant CEOs or Chairman’s of the Board.
Origins and Synopsis of the Case
The dispute stems from compensation plans approved by Tesla for its CEO Mr. Musk in 2009 and 2012. The latter’s goals were close to being met much earlier than the end of the ten-year span set for such goals. To address this, the 2018 grant was proposed, offering Mr. Musk an exceptional chance to significantly increase his stake in Tesla by hitting a very ambitious market capitalization and aggressive operational benchmarks. The plan was structured with 12 traches, each entitling Mr. Musk to shares equal to 1% of Tesla’s share capital, tied to market capitalization, revenue targets and profitability (to give some idea about how aggressive these targets were – the company needed to grow by 1,000% in market cap and increase its revenues to more than General Motors had at that time). The 2018 grant was referred to as “the largest potential compensation opportunity ever seen in public markets.”
Tesla’s board noted that “Our aspirations may appear ambitious to some, and impossible to others, and that is by design. We like setting challenging, hard-to-achieve goals for ourselves, and then focusing our efforts to make them happen. This is why we based this new award on stretch goals and why we gave Elon the ability to share in the upside in a way that is commensurate with the difficulty of achieving them.”
To avoid being subject to the “entire fairness” standard, the most demanding level of judicial scrutiny under Delaware law, with respect to the compensation package approved by it, Tesla’s board of directors brought this unique award before the stockholders of Tesla, to obtain an approval by a disinterested majority (i.e., a majority among the stocks not held by “controlling stockholders” or stockholders with “personal interest” in the approval of such proposal). The compensation package was approved by a disinterested majority of 73%. This very unorthodox compensation scheme faced scrutiny when stockholder Richard Tornetta challenged its validity, claiming investor deception and undue influence exerted by Mr. Musk over Tesla’s board. The court thoroughly examined these allegations, ultimately ruling in Mr. Tornetta’s favour — particularly with regards to Mr. Musk’s control over the grant approval process.
Concerns over the Approval Process
Chancellor Kathaleen McCormick, from the Delaware Chancery Court, cited several significant issues relating to how Mr. Musk’s compensation was approved.
The Chancellor McCormick found that Mr. Musk’s dual roles as CEO and Chair (at that time), along with his status as founder, afforded him considerable sway over the board’s decision-making. In addition, Mr. Musk had significant personal and business relationships with several board members — including a close relationship with the chair of the compensation committee. As a result, Chancellor McCormick suggested that the negotiation process was compromised or even non-existent, indicating that Mr. Musk effectively set his own compensation. Moreover, she noted that the approval process failed to adhere to customary benchmarking practices that are standard in weighing comparable executive compensation packages.
The judge ruled that the proxy statement, presented to the stockholders of the company with the intention to avoid the application of the entire fairness standard, failed to provide full and accurate disclosure of the approval and negotiation process and even contained misleading statements regarding the independence of the board and compensation committee members. Therefore, despite the stockholders’ approval by a disinterested majority, the company had to face the burden of showing that the compensation package was entirely fair.
The Chancellor also noted that, when asked to approve a transaction, stockholders are entitled to a full and accurate description of all the material stages in the board or committee processes that resulted in the transaction. However, in this case, the proxy statement did not disclose the level of control that Mr. Musk exercised over the process — e.g., his control over the timing, the fact that he made the initial offer, the fact that his initial offer set the terms until he changed them six months later, the lack of negotiations, and the failure to review any benchmark information.
Outcome and Legal Standard Imposed
After the determination that the “entire fairness” standard should be applied, the defendants had the task of proving the compensation plan’s fairness, a burden they were unable to satisfy. Furthermore, they failed to convince the court that the stockholder vote on the compensation package was fully informed. Consequently, Chancellor McCormick ordered the plan’s rescission.
Future Guidance
The Tesla ruling calls into question the existing assumptions around who is deemed to be a controlling shareholder under Delaware case law or at least creates some new standard of control by dominant executives and/or significant shareholders in Delaware companies.
The ruling also examines the question of directors’ independence in a manner that it less technical and dry, looking at the essence of the relationships and the influence of Mr. Musk on each of the directors.
This means that in certain circumstances where there are dealings with dominant executives and/or significant shareholders it will be difficult to assess whether such dealing will be reviewed under the business judgment rule or rather be subject to the entire fairness standard. It also makes it more difficult to ascertain whether a certain director is independent or not, or if such director is not independent in a certain context – there were no clear rules set for determining the level of relationship or influence that create dependency.
While it is clear that this specific case takes a lot of the circumstances to the extreme, the legal reasoning and rhetoric behind the decision will very likely affect other future cases.
Under the Israeli case law, the Supreme Court has ruled that in significant deals with controlling shareholders, the best practice for avoiding an equivalent of an entire fairness review by the court, is to appoint an independent committee to negotiate the deal with the controlling shareholder and then bring the deal for the approval of a majority of the minority shareholders. The Supreme Court indicated that there is always room for the courts to intervene and review of such deals, but that where the above process was properly applied, the court will not intervene to try and determine entire fairness – but rather accept such deals as long as they are within the realm of fairness.
We can expect the Tesla ruling to raise the independency standards for the independent committee and the increase the disclosure standards in the notices to the shareholders when calling for their approval of such deals.
We recommend that companies, whether incorporated in Delaware or in Israel, be much more careful when conducting any approval process that involves its controlling shareholders, significant shareholders that may be deemed to have certain control power and involving their CEO or chairman of the board. Also, looking at the Tesla case as a potential precedent, it is recommended to consider such control or influence upon the directors also in a situation specific context.
The key takeaway of what can be done to avoid future court intervention with these sort of interested party arrangements is to make sure that there is a real negotiation process around such dealings, conducted by parties that are clearly independent of the counterparty and assuring there is clear evidence of the process. In addition, if the company brings such dealing for shareholder approval, it’s important to provide full and accurate disclosures of the process as well as of the terms being approved. This is especially true when the negotiated deal is unique in nature or circumstances and is hard to properly compare to other similar deals, or when the arrangement deviates from its comparable deals.
This case reinforces the need to maintain best practices in corporate governance and compensation planning in general. If you have any questions or concerns about controlling shareholder deals, compensation practices or other corporate governance matters, please do not hesitate to contact us for personalized advice.
This update is provided as general information only and may not be relied upon in any individual case without additional legal advice.
