Subsequent to the post-trial opinion by Chancellor McCormick in January 2024, Tesla appointed a new independent director to serve on a newly created independent committee, which issued a report recommending that stockholders approve the prior package. Tesla then sought and obtained a second stockholder ratification of the package (the “Stockholder Ratification”). In this latest opinion, the Court held that Tesla’s implementation of a renewed process reviewing the package and a second stockholder approval was both procedurally improper and substantively inadequate to justify modification of the post-trial order.
Key takeaways
- In conflicted-controller transactions, the presumptive standard of review is entire fairness. To shift the standard of review from entire fairness to business judgment, the controller must commit to MFW protections prior to engaging in economic negotiations, with the company both: (1) establishing an independent, adequately empowered special committee that fulfills its duty of care, and (2) conditioning the transaction on an uncoerced, informed vote of a majority of the minority stockholders.
- The mere ratification by a fully informed majority of minority stockholder vote is insufficient to shift the standard of review to business judgment. At most, it may shift the burden of proving entire fairness from the defendant back to the plaintiff.
Initial case
In June 2018, a Tesla stockholder filed a lawsuit alleging breach of fiduciary duty by Tesla’s board of directors for approving a USD55.8bn compensation package for Elon Musk, the largest in public company history. Following a trial the Court found that at all relevant times, Tesla’s board was comprised of nine directors. While Musk and his brother recused themselves from voting on the compensation package, the Court scrutinized the independence of the standing compensation committee responsible for approving it. Two of the committee’s directors were close personal friends of Musk, regularly vacationing and co-investing with him. The trial testimony included facts indicating that all four members of the committee had amassed substantial personal wealth as Tesla directors, an amount that was reportedly “life-changing” for one of them.2 Therefore, the Court held that because each of the four compensation committee members held various personal and business ties to Musk, they lacked independence.
Furthermore, the Court found that Musk was a controller with transaction-specific control over Tesla. Musk owned 21.9% of outstanding Tesla common stock, giving him “a sizeable leg-up for stockholder votes generally,” “the ability to block specific categories of bylaw amendments,” and “great influence in the boardroom.”3 In addition, the Court found that Musk was a “superstar CEO,” chair, and founder of the company.4 Tesla depended on Musk’s managerial authority and believed in Musk’s “singular importance” to Tesla, giving him a unique balance of power with the board and stockholders.5
Given the identified conflicts and the “risks inherent in a corporation’s transactions with its controlling stockholder,” the Court determined that the approval of the compensation package was subject to the enhanced “entire fairness” standard of review.6 Under that standard, the burden of proof is on the Defendants—the Tesla directors—to prove that the compensation package was fair in terms of both process and price. The Court ultimately found that Defendants failed to meet this burden. Key elements of the package, including Musk’s control over the timing of the grants, had gone unchallenged, and there was no evidence that the committee considered alternatives or imposed significant oversight. As such, the Court concluded that the board’s approval process was fundamentally flawed. Moreover, although Tesla obtained stockholder approval of the package, the Court determined that the disclosures concerning the composition of the committee and negotiation of the package were inadequate, rendering the vote of approval insufficient to shift the burden to the plaintiffs to prove that the package was not entirely fair. In addition to the lack of fair process, the Court held that the size of the package was also unjustifiable. Three of the operational milestones already matched Tesla’s internal projections and the board “deemed some of the milestones 70% likely to be achieved soon after the [g]rant was approved.”7 The Court found unpersuasive arguments that the package was an “incentive” for Musk to focus on Tesla, noting that Musk stated “unequivocally” at trial that he “would have remained at Tesla even if stockholders had rejected a new compensation plan” and had “no immediate plans to resign.”8
As a result, the Court ruled in favor of the Plaintiff, finding the compensation package invalid and ordering its rescission.
Tesla’s actions post-trial opinion
Following the Court’s post-trial opinion rescinding the compensation package, Tesla took significant steps to reinstate it. Shortly after the ruling, Tesla appointed a new two-director committee to re-review the compensation package, after which one of the directors resigned from the committee due to social ties with Musk. This move was intended to respond to the Court’s criticisms about the lack of independence among board members involved in the initial approval process. Tesla also decided to reincorporate into Texas, but it affirmatively agreed that it would not preclude the Court from exercising jurisdiction over the matter.
On April 29, 2024, Tesla distributed a proxy statement seeking ratification from its stockholders of the compensation package. The proxy statement included a comprehensive report issued by the newly appointed independent director containing an in-depth explanation and evaluation of the proposal, aiming to establish procedural fairness and transparency. Tesla emphasized in its proxy statement (which also included as an annex the full text of the post-trial opinion) that it believed the changes addressed prior deficiencies highlighted by the Court, including the absence of meaningful negotiation and oversight in the original approval process, and that a ratification vote would “extinguish” the Court’s post-trial ruling.
On June 18, 2024, 72% of Tesla shares held by disinterested stockholders voted in favor of the compensation package, signaling widespread approval by Tesla investors. Shortly thereafter, Tesla filed a Motion to Revise the Post-Trial Opinion, arguing that stockholder ratification effectively cured any fiduciary duty breaches associated with the original approval process. As the Court stated, Defendants’ argument rested on the belief that “transactions resulting from breaches of the duty of loyalty can be put to a stockholder vote at any time for any purpose—including to extinguish already adjudicated claims or reverse the outcome of a court decision.”9
The court denies the motion to revise
In its latest decision, the Court addressed two issues. The first was the Defendants’ argument that under the common law doctrine of ratification, the June 2024 Stockholder Ratification cured the conflicted transaction and compensation package—asserting in the proxy statement, if not before the Court, that the fully informed stockholder vote was an “elixir that could cure fiduciary wrongdoing.”10 The Court rejected the ratification argument for four independent reasons, two of which were procedural, one which was substantive, and one which was disclosure-related.
1. Newly created evidence is procedurally barred from admission
Tesla sought revision of the Court’s post-trial opinion based on new evidence regarding the Stockholder Ratification under Rules 54(b), 59(a) and 60(b) of the Court of Chancery Rules. As the Court pointed out, Rules 59(a) and 60(b) allow a court to consider “newly discovered evidence,” but not “newly created evidence,” like the June 2024 Stockholder Ratification. The Court thus deemed that evidence inadmissible under those rules.11 The Court reached the same conclusion under Rule 54(b), relying on the law-of-the-case doctrine.12
In coming to these conclusions, the Court noted that allowing post-trial stockholder votes to retroactively validate challenged decisions would render litigation “interminable,” potentially undermining derivative suits by enabling defendants to nullify judicial findings through after-the-fact stockholder ratifications.13
2. The defense of stockholder ratification was not timely raised
The Court next noted that stockholder ratification is an affirmative defense and must therefore be raised in a timely manner, or it is waived. In this case, the Defendants had (necessarily) failed to raise the defense of stockholder ratification until after trial, leaving its acceptance to the Court’s discretion.
Defendants relied on Kerbs v. California Eastern Airways in support of their argument that the Court should exercise discretion in their favor.14 The Court found the case inapplicable, however, noting that neither Kerbs nor any other Court of Chancery ruling has allowed a party to raise stockholder ratification as a defense post-trial for the identified purpose of convincing the court to “alter (much less flip) its judgment.”15 Pointing out that Defendants raised the defense of stockholder ratification six years after the case was filed, eighteen months after trial, and five months after the post-trial opinion, the Court declined to permit the late defense.16
3. The stockholder vote alone could not ratify a conflicted-controller transaction
Substantively, Defendants relied on agency law to support their ratification argument, arguing that directors act as agents of stockholders, who are principals of the corporation, and that, stockholders could therefore choose to vote “to adopt any corporate acts they deem in their own best interests.”17 While noting that stockholder ratification “draws by analogy from agency principles,” the Court rejected the notion that directors act as stockholders’ agents, noting that “Delaware law has long treated directors as analogous to trustees for [stock]holders.”18
The Court acknowledged that Delaware recognized two forms of stockholder ratification: (1) legal ratification, which “allows stockholders to bestow legal authority on a corporate act in circumstances in which the agent had no authority or arguably had no authority at the time he acted”; and (2) fiduciary ratification, which “allows stockholders to express, through an affirmative vote, their view that a corporate act is consistent with [stock]holder interests.”19 Although the Defendants had originally raised both forms of ratification as bases for relief, by the time of the argument, they relied only on fiduciary ratification.
The Court then clarified that “[t]he effect of fiduciary ratification varies depending on the corporate decision at issue.”20 Specifically, the Court noted that fiduciary ratification could:
- “act as a complete defense”;
- “shift the substantive test on judicial review”;
- “shift the burden of proof”; or
- “have no effect that [deserves] judicial recognition.”21
To determine which of these effects a stockholder vote has on a corporate decision, Delaware courts first identify the type of decision or transaction at issue. Transactions with more direct and serious conflicts of interest are subject to weaker effects of fiduciary ratification, just as they merit stricter standards of review.
In the case of conflicted-controller transactions, such as Musk’s proposed payment package, conflicts of interest directly “threaten the decision-making process” within a company.22 Thus, the Court held that “the maximum possible effect of stockholder ratification in a conflicted-controller transaction” would be to shift the burden of proof from the defendant to the plaintiff, rather than changing the standard of review or establishing a complete defense.23 Because conflicted-controller transactions present multiple risks to minority stockholders, the appropriate standard of review to apply to conflicted-controller transactions, per the Delaware Supreme Court in Match,24 is the entire fairness standard.
The Court then reiterated that to benefit from a more deferential business judgment review, defendants must strictly adhere to the requirements set forth in MFW:25 (1) “an independent, adequately empowered special committee that fulfills its duty of care” and (2) “an uncoerced, informed vote of a majority of the minority stockholders.”26 A controller must commit to these MFW protections before the start of economic negotiations in order to prevent a controller from using MFW protections as a bargaining chip. Where such “precommitment” is absent, the entire fairness standard applies.27
In this case, Musk and the Tesla board did not commit to MFW’s protections before engaging in negotiations on the compensation package. They began negotiating the terms in 2017, but the board did not even purport to apply the MFW protections until the 2024 post-trial review. Accordingly, the Court found that the conditions were not in place “before the start of economic negotiations” (or even as of the board’s approval of the pay package) and that entire fairness applied.28
The Court likewise rejected Defendants’ assertion that business judgment should apply because the protections were in place before Tesla’s June 2024 Stockholder Ratification. The Court explained that, to the contrary, MFW protections must be in place from the inception of the contemplated transaction, not the vote, to warrant a business judgment review: “[o]ne does not ‘MFW’ a vote, which is part of the MFW protections; one ‘MFW’s’ a transaction.”29 If compliance with MFW could be achieved by simply “submitting a rescinded transaction to a second, later vote, then the ‘up-front precondition’ requirement of MFW would have little meaning, and MFW would fail to fulfill its central objective.”30
4. The Proxy Statement was materially misleading
The Court also found that the proxy statement issued in support of the June 2024 Stockholder Ratification was in all events misleading, undermining Defendants’ contention that they had complied with MFW—even at the ratification stage. More specifically, the Court held that the following statements were misleading considering its ruling that the Stockholder Ratification could not procedurally “extinguish an adjudicated breach of the duty of loyalty” or substantively “cleanse a conflicted-controller transaction absent the full suite of MFW protections”31:
- The vote could “extinguish claims for breach of fiduciary duty by authorizing an act that otherwise would constitute a breach.”
- “[T]he deficiencies, including disclosure deficiencies, procedural deficiencies, and breaches of fiduciary duty, identified by the Delaware Court in connection with the Board and our stockholders’ original approval of the 2018 CEO Performance Award should be ratified and remedied and any wrongs found by the Delaware Court in connection with the 2018 CEO Performance award should be cured.”
- “[I]f the 2018 CEO Performance Award is ratified, those options will be restored to Mr. Musk. As a result, Mr. Tornetta may not be considered to have rendered the ‘benefit’ to Tesla through his lawsuit that is claimed by his attorneys”; and
- “A new stockholder vote allows the disclosure deficiencies found by the Tornetta court to be corrected, among other things.”32
The Court specifically ruled that these statements were not saved by the proxy statement’s risk factor disclosures “that a court ‘may find that the Ratification is not fair to stockholders . . . or that the Ratification is otherwise legally defective,” because that phrasing did not “fully capture the issues.”33
After addressing the stockholder ratification points, the Court addressed the second issue of the Plaintiff’s fee petition, raising concerns about the potential for disproportionate attorney fees in “megafund” cases.34 Recognizing the risk of a windfall for legal counsel, the Court applied a stage-of-case approach to calculate fees. The Court applied a 15% baseline calculation to the benefit of the rescission value of USD2.3bn, resulting in a fee award of USD345 million, which the Defendants can elect to pay in cash or freely tradable shares of Tesla common stock.
Our view
The Court’s ruling in this latest opinion highlights the importance of procedural fairness, transparency, and adherence to fiduciary duties in corporate governance. Tesla attempted to ratify and reinstate the previously rescinded compensation package through a second stockholder vote post-trial, but the Court rejected these efforts, finding that stockholder ratification was insufficient to cure the breaches of fiduciary duty committed by the board in approving Musk’s USD55.8bn compensation package. This case serves as a reminder of the heightened standard corporate boards must meet to ensure effective corporate governance in conflicted controller transactions and that transaction participants must commit to both prongs of the MFW requirements at the outset of discussions to benefit from the lower business judgment rule standard when facing the inevitable challenges to those transactions. Further, this case makes clear that stockholder approval is not a universal “elixir [to] cure fiduciary wrongdoing.”35
Footnotes
1. Tornetta v. Musk, December 2, 2024 at 16.
2. Tornetta v. Musk, January 30, 2024 at 125.
3. Id. at 115.
4. Id. at 2.
5. Id. at 121.
6. Id. at 1; For further discussion of conflicted controller transactions, please refer to John Cannon, 2024 Developments: Delaware Law on Controlling Stockholder Transactions, A&O Shearman Corporate Governance and Executive Compensation Survey (2024).
7. Id. at 186.
8. Id. at 38.
9. Musk, December 2, 2024 at 17.
10. Id. at 15.
11. Id. at 18.
12. This doctrine is a public policy that generally discourages the “reopening” of issues of law previously decided by a court in a “procedurally appropriate way” to prevent “a defendant from taking two bites of the apple.” (Id. at 21-22).
13. Id. at 24-26.
14. 90 A.2d 652, 659 (Del. 1952). The Delaware Court of Chancery permitted the defendant to raise an affirmative defense based on a stockholder vote that occurred after litigation and before appeal. Kerbs v. California E. Airways, 94 A.2d 217 (Del. Ch. 1953).
15. Musk, December 2, 2024 at 34.
16. Id.
17. Id. at 34-35.
18. Id. at 35.
19. Id. at 36-37.
20. Id. at 37.
21. Id. (quoting Lewis v. Vogelstein, 699 A.2d 327, 335 (Del. Ch. 1997)).
22. Id.
23. Id. at 38.
24. In re Match Group, Inc. Derivative Litigation, No. 368,2022 (Del. Apr. 4, 2024). Prior to Match, the MFW framework, which affords a defendant a business judgment standard of review under certain conditions, had limited applicability outside of the freeze-out merger context. Match expanded MFW’s application to other controller contexts, including conflicted-controller transactions. In a conflicted-controller transaction, the Court clarified that entire fairness, and not business judgment, is the presumptive standard of review; for business judgment to apply, both procedural prongs of MFW must have been satisfied by the defendant before commencement of the transaction in question.
25. Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014) (holding that a defendant involved in a freeze-out merger transaction can shift the standard of review to the more favorable business judgment rule, provided that two conditions are satisfied: (1) approval by an independent, disinterested special committee fulfilling its duty of care, and (2) an uncoerced, informed vote of a majority of the minority stockholders. This framework’s application was expanded to conflicted-controller transactions in Match and is referred to today as the MFW framework).
26.Musk, December 2, 2024 at 39.
27. Id.
28. Id. at 40.
29. Id.
30. Id.
31. Id. at 42.
32. Id.
33. Id. at 43.
34. Id. at 48.
35. Id. at 15
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