Delaware, Elon Musk, and Compensation

Background

• A Tesla stockholder sued Elon Musk and Tesla, saying that the Tesla board breached its fiduciary duties by awarding Musk an unusually large compensation package.
• By default, Delaware courts don’t question business decisions like compensation.
  • This is known as the "business judgment rule".
• An exception is when there is a conflict of interest (i.e. a risk of self-dealing).
  • This can happen when a company sets compensation for someone who controls the company, since they might try to give themselves more compensation at the expense of other stockholders.
  • The court found Elon Musk to have control of the company with respect to his compensation because the majority of the compensation committee were Musk's friends or beholden to him in some way.

"Entire Fairness" Standard

• If there is a conflict of interest, Delaware courts use a standard known as "entire fairness" instead of the "business judgment rule".
  • The "entire fairness" standard is well-established case law.
  • The standard has two aspects: "fair price" and "fair dealing" (whether a "fair process" was followed in making the decision).
• If the decision was approved by fully-informed, disinterested stockholders, the plaintiff has the burden of proof to show that the "entire fairness" standard was not met.
  • The plaintiff in this case was the stockholder suing Elon Musk.
  • To fully inform the stockholders, the company needs to tell the stockholders if any of the decision-makers had a conflict of interest.
  • The company also needs to tell the stockholders important details about the process it followed in making the decision.
• Tesla got consent from disinterested stockholders, but the court found it wasn't fully informed.
  • Tesla didn't tell stockholders about conflicts of interest with the compensation committee. Instead, Tesla told stockholders that the compensation committee was fully independent.
  • Tesla also didn't disclose that the compensation committee had not actually tried to negotiate the compensation or do any customary benchmarking.
• As a result, the burden of proof was on Elon Musk's lawyers to prove the "entire fairness" standard had been met.

Failure to Prove "Entire Fairness"

• The court found that Elon Musk's lawyers proved neither "fair dealing" nor "fair price", the two aspects of the "entire fairness" standard.
• The court found "fair dealing" hadn't been proved in part because there was no real negotiation of the compensation package. The compensation committee members testified that they were just cooperating with Musk.
• Musk's lawyers tried to prove "fair price" seven different ways but didn't persuade the court with any of them.
  1. The compensation package Tesla gave to Elon Musk was worth the increased alignment and commitment Tesla got from him.
     • The court wasn't persuaded that what Tesla gave was necessary to get Musk's alignment and commitment.
       • Musk's large ownership stake in Tesla already aligns him with Tesla.
       • Other founders like Zuckerberg, Bezos, Gates, etc. with large ownership stakes in their companies didn't need additional compensation to remain aligned and committed to their companies.
       • Musk testified he would have stayed with Tesla even without the compensation package.
       • There was evidence at trial that the size of the compensation package was based on goals Musk had that weren't related to Tesla.
  2. It was a precarious time for Tesla, and Musk required "dopamine hits" to be incentivized to stay at the helm.
     • The court was not convinced by this because the compensation package terms didn't require Musk to spend any particular amount of time or energy working on Tesla, weakening the argument that the board was worried about incentivizing Musk to focus on Tesla.
  3. The structure of the compensation package contained provisions and stockholder protections that resulted in only upside for stockholders.
     • The court agreed that the compensation package's structure had some value as far as protecting stockholders, but this wasn't enough to prove fair price.
  4. The milestones Musk had to accomplish were "audacious" and "extraordinarily ambitious".
     • The court wasn't convinced by this argument because, at the time of the grant, three of the milestones were projected to be achieved anyways, and others were estimated at the time to have a 70% chance of being achieved.
  5. The compensation was similar to what a CEO would get when hired for a VC or PE-backed company.
     • The court didn't find this persuasive because Tesla wasn't a VC or PE-backed company, and Musk already owned a large percentage of the company.
  6. The package was approved by a majority disinterested stockholder vote.
     • As the court determined earlier, the stockholders weren't fully informed. As a result, the stockholder consent couldn’t be used as evidence of "fair price".
  7. Because Tesla thrived as a result of the compensation package, the price was fair in hindsight.
     • The court couldn't find proof that the compensation package was solely or directly responsible for Musk's efforts, so did not find this argument to prove a fair price.

Outcome

• Because the court found that Elon Musk's lawyers didn't prove either "fair dealing" or "fair price", the two aspects of the "entire fairness" standard, it ruled in favor of the plaintiff.
• The plaintiff had asked for rescission of the grant, which was supported by case law as a valid remedy. Elon Musk's lawyers hadn't proposed any viable alternative, so the court ordered full rescission of the grant.