In Tornetta v. Musk, Delaware Chancery Court Applies Entire Fairness Review to Board's Grant of Incentive Compensation Award to Controlling Shareholder

Practical Law Legal Update w-022-1437 (Approx. 6 pages)

In Tornetta v. Musk, Delaware Chancery Court Applies Entire Fairness Review to Board's Grant of Incentive Compensation Award to Controlling Shareholder

by Practical Law Employee Benefits & Executive Compensation

Background

In January 2018, Tesla's board of directors approved an incentive-based compensation package for Tesla's chief executive officer (CEO) and chief product architect, Elon Musk. Musk is also the controlling shareholder, owning almost 22% of Tesla's common stock. Musk's compensation package was composed of stock options that vest in 12 tranches, with vesting tied to Tesla reaching certain "capitalization and operational milestones." Any options that do not vest within ten years are forfeited. In addition, when a milestone is met, Musk must be serving as either CEO or both executive chairman and chief product officer for the option to vest. If none of the milestones is met, Musk will receive nothing under the plan. If all the milestones are met, however, the value of the vested options may be as high as $55.8 billion. Tesla estimated the options' preliminary aggregate fair value at $2.615 billion in its proxy statement.

Grant of the award was contingent on a favorable vote by a majority of disinterested shares voting at a March 2018 special meeting of Tesla shareholders. In February 2018, Tesla submitted a proxy proposal describing the compensation award and recommending that shareholders approve the award. Of the disinterested shares at the March 2018 special meeting, 73% voted to approve the award (which equaled about 47% of all the outstanding disinterested shares).

After the approval was announced, the plaintiff, a Tesla shareholder, sued Musk, Tesla, and the directors, asserting:

Direct and derivative claims for breach of fiduciary duties against Musk and the directors.
A direct and derivative claim for unjust enrichment.
A derivative claim for waste against the directors.

The defendants filed a motion to dismiss.

Outcome

The court granted in part and denied in part the motion to dismiss. Regarding the breach of fiduciary duty claims, the court concluded that entire fairness was the appropriate standard of review. Under that standard, the plaintiff adequately alleged that the award was unfair, and therefore stated a claim for breach of fiduciary duty. The court also declined to dismiss the unjust enrichment claim but dismissed the waste claim.

Breach of Fiduciary Duty

Entire Fairness Standard Applied

The court first addressed the threshold issue of whether it should review Musk's award under the business judgment rule or the entire fairness standard for purposes of resolving the motion to dismiss. The court acknowledged that a board's grant of executive compensation is typically entitled to "great deference" under Delaware law. It noted, however, that board transactions involving "conflicted controllers" are generally subject to entire fairness review. Accordingly, the standard of review question presented an issue of first impression for the court.

Defendants argued that business judgment review should apply because the shareholders ratified the board's decision. In response, the plaintiff argued that:

The vote was structurally inadequate because the award was not approved by a majority of all outstanding disinterested shares.
Even if the vote might otherwise be structurally adequate, the vote could not ratify the award because the controlling shareholder was the beneficiary.

Rejecting the plaintiff's argument regarding the structural adequacy of the vote, the court reasoned that Delaware law does not require grants of equity or other compensation to directors or officers to be approved by a majority of all outstanding disinterested shares. In the court's view, the vote met the ordinary course requirements for shareholder ratification of the board's decision because the vote met Delaware General Corporation Law requirements concerning quorum and the minimum affirmative vote threshold (8 Del. C. § 216(1), (2)) and Tesla's charter and bylaws did not specify different requirements.

The court acknowledged that the ratifying vote would normally entitle the defendants to business judgment review, but noted that the situation is different when a conflicted controller is involved. Because the award benefitted a conflicted controller, the shareholder vote could not ratify the board's decision if there was evidence that the structure or circumstance of the vote was coercive. According to the court, the option award raised coercion concerns because it benefitted the company's controlling shareholder, so the minority shareholders would have reason to fear controller retribution if they voted against the award. Additionally, the court found that the plaintiff adequately alleged that the board's and compensation committee's decision-making processes involved a coercive influence. As a result, the court determined that it should review the award under the entire fairness standard.

The court noted that the defendants could have received business judgment deference if they had preconditioned the controlling stockholder's compensation package on the dual protections set out in In re MFW Shareholders Litigation, 67 A.3d 496 (Del. Ch. 2013)). In MFW, the Chancery Court held that transactions involving a conflicted controller are subject to the more deferential business judgment review if the transaction is conditioned upfront on the approval of both:

An independent, fully functioning special committee of the board.
An uncoerced and informed vote by a majority of the minority shareholders.

In order for the timing component of MFW to be met, the dual protections must be in place "ab initio" or upfront before any "substantive economic negotiations" take place. (See Practice Note, Fiduciary Duties in M&A Transactions: Business Judgment Rule Using Procedural Protections and Timing of MFW Conditions: Ab Initio.)) The court noted that had the Tesla board conditioned Musk's compensation award on these two approvals before any substantive economic negotiations began, "the Court's reflexive suspicion of Musk's coercive influence over the outcome would be abated" and the business judgment standard of review would have applied (, at *14.)

Defendants argued that the "dual protections" of MFW are limited to "transformational transactions," such as mergers, involving conflicted controllers where Delaware law requires approval by the board and shareholders. The court rejected this distinction, finding that the dual protections of MFW would protect minority shareholders in other transactions involving conflicted controllers.

Plaintiff Adequately Pled That Award Was Unfair

Having determined that entire fairness applied, the court next addressed whether the plaintiff's allegations were sufficient to state a claim for breach of fiduciary duty. Applying Kahn v. Lynch Communication Systems (638 A.2d 1110 (Del. 1994)), the court concluded that the defendants demonstrated that the award was conditioned on a vote of the majority of minority shareholders, and therefore the burden of persuasion shifted to the plaintiff. The plaintiff alleged that the value of the award had "a potential value that is orders of magnitude higher than what other highly paid CEOs earn." According to the court, these allegations were sufficient, though just barely, to allege that the award was unfair.

Unjust Enrichment

The court denied the motion to dismiss with respect to the unjust enrichment claim, even though it duplicated the breach of fiduciary duty claims, reasoning that Delaware law did not preclude plaintiff from asserting both claims.

Waste

In dismissing the waste claim, the court found that the plaintiff failed to allege facts indicating that "no person of ordinary sound business judgment could view the benefits received in the transaction as a fair exchange for the consideration paid by the corporation." In addition, the court found it relevant that a majority of the disinterested shareholders at the special meeting voted to approve the award.

Practical Implications

The Tornetta v. Musk decision is at the motion to dismiss stage and it therefore remains to be seen what the outcome will be if the case is decided on the merits. However, this ruling is another indication that Delaware courts will review conflicted compensation decisions under the entire fairness standard instead of the more deferential business judgment standard unless certain procedural safeguards are met. While compensation grants to executives who are also controlling shareholders may not be common, companies making such grants should:

Consider establishing formal procedures that must be followed in connection with any such grants, which should include preconditioning the approval for the grants upfront (before any substantive economic negotiations take place between the executive and the company) on both:
- the negotiation and approval of the award by an independent, fully functioning special committee of the board; and
- the subsequent approval by the fully informed vote of the holders of a majority of the disinterested shares.
Consult with their outside counsel before making any such grants.

In Tornetta v. Musk, Delaware Chancery Court Applies Entire Fairness Review to Board's Grant of Incentive Compensation Award to Controlling Shareholder | Practical Law