Tesla’s Board Failed To Meaningfully Negotiate Musk's $55B Compensation Package

         On January 30, 2024, the Delaware Chancery Court issued a trial decision invalidating Elon Musk’s $55B performance-based equity compensation plan. The Court noted that the $55.8B maximum value equity grant (the “Grant”), “is the largest potential compensation opportunity ever observed in public markets by multiple orders of magnitude-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.” Because the Tesla Board failed to engage in any meaningful negotiations with Musk—and, also failed to prove that the Grant represented “fair value” to the Tesla shareholders—the Court rescinded the Grant and Musk is currently without an equity compensation plan.  
 
            The threshold question addressed by the Court was whether Musk controlled Tesla. This was a critical question because it in turn determined whether the Court would apply the business judgment rule – giving the Board great discretion over the amount of the Grant – or apply the “entire fairness standard”, which shifts the burden of proof to the Board and requires the Board to prove that the value of the Grant was “entirely fair”. The Court noted that in two previous Delaware court decisions involving Musk and Tesla, the Court had avoided determining whether Musk “controlled” Tesla. Now, the Court would “boldly go where no [Delaware court] had gone before” and finally address the issue of whether Musk controlled Tesla.
 
            In a detailed analysis of the trial evidence[1], the Court found that for purposes of the transaction at issue – the Grant – Musk controlled Tesla. This “transaction” control was based upon the following findings: (i) Musk’s intimate ties to three of the eight directors “rendered those directors beholden to him”; (ii) those directors constituted half the board since one of the directors departed; and (iii) the remaining directors acted beholden to Musk “allowing Musk to dictate the timing of the process and the terms of the Grant”. To this point, the Court found:
 
            Ultimately, the key witnesses [the directors] said it all - they were there to cooperate with Musk, not negotiate against him. This unique suite of allegations makes it undeniable that, with respect to the Grant, Musk controlled Tesla.

           Because Musk “controlled” the transaction at issue, the transaction involved a conflicted controlling shareholder. As per established Delaware law, transactions involving a conflicted controlling shareholder are reviewed under the light of the “entire fairness” standard of review. Pursuant to the “entire fairness” standard of review, the burden of proof shifted to the Board to prove that the terms of the Grant were “entirely fair”. To do this, the Board had to prove that the “process” was fair and that the “value” of the Grant was fair value. These two elements of proof are not a bifurcated test as between fair dealing and fair price. “All aspects of the issue must be examined as a whole since the question is one of entire fairness.”[2]

           As to the fairness of the process, the Court found many reasons that the process was unfair, with the most “pivotal” factor being the failure of the Board to meaningfully negotiate with Musk. On this point the Court stated:

 Rather than negotiating against Musk, the committee engaged in a ‘cooperative [and] collaborative’ process antithetical to arm’s-length bargaining. Worse, the committee seemed to actively advance Musk’s interests-doing ‘what feels fair’ for Musk – including by devising ways to understate the Grant’s value on the grant date and make the milestones easier to achieve. Those were ‘exercise[s] in rationalization’. In the end, Musk dictated the Grant’s terms, and the committee effected those wishes. [3]

           Next, the Court turned to fair price. The Court noted that there is no absolute limit on the magnitude of a compensation grant that could be considered fair. “But process can infect price.” And “where the pricing terms of a transaction that is the product of an unfair process cannot be justified by reference to reliable markets or by comparison to substantial and dependable precedent transactions, the burden of persuading the court as to the fairness of the terms will be exceptionally difficult.[4]    

         Because of the unprecedented size of the Grant, the Board could not turn to reliable markets or to substantial and dependable precedent transactions to prove fair value. Instead, the Board tried to prove fair value through an array of subjective arguments, none of which proved successful. Factors that proved insurmountable for the Board were the fact that (i) Musk owned 21.9 percent of Tesla at the time of the Grant and was already very incentivized to see the company succeed; (ii) all of the evidence pointed to the fact that Musk was never leaving the company, so the Grant was not necessary to retain him, and (iii) the Grant ignored profitability, granting Musk billions of dollars even though he may not achieve Tesla’s profitability goals.       

         The Court found that the Board failed to meet its burden of proving fair process and fair value and found that the Grant did not satisfy the entire fairness test. Given the Board’s failure to prove entire fairness, the Court turned to the requested remedy – rescission. Noting that no third- party interests were involved in the Grant and that the options in the Grant had not been exercised and could be unwound, the Court held that rescission was the proper remedy and voided the Grant. By rescinding the Grant, the parties were restored to the position they were in prior to the Grant.

        As one could imagine, Musk does not agree with the decision and following the decision, he tweeted “Never incorporate in Delaware”. While it remains to be seen if Musk and Tesla will appeal, the Court’s decision serves as a treatise for all Delaware boards grappling with the issues of executive compensation and should be required reading. Should you have questions about this case or have a case you would like to discuss that involves conflicted shareholder transactions or similar issues, please reach out to Douglas Hirsch at dhirsch@sadis.com.