An extraordinary performance-based stock option plan (the “Grant”) awarded by Tesla, Inc. (“Tesla”) to Elon Musk (“Musk”) was invalidated by the Delaware Court of Chancery last week, despite the fact that over 70% of Tesla’s disinterested stockholders approved it at a 2018 special meeting. The Grant, described in the court’s 200-page opinion as “the largest potential compensation opportunity ever observed in public markets by multiple orders of magnitude,” had a maximum value of $55.8 billion.
What led to this outcome, which prompted Musk to tweet on X, “Never incorporate your company in the state of Delaware,” and conduct a social media poll asking whether Tesla should change its state of incorporation to Texas? Key points follow.
- The Grant was awarded to Musk on January 21, 2018. It features 12 vesting tranches tied to the achievement of one market capitalization milestone and one milestone based on revenue or adjusted EBITDA. The market cap milestones start at $100 billion, increasing in $50 billion increments, and end at $650 billion. Upon the completion of a tranche, Musk has the right to purchase 1% of Tesla’s outstanding common stock as of January 19, 2018. The strike price was $350.02, the closing price on January 19, 2018.
- Prior to the Grant, Musk had beneficial ownership of 21.9% of Tesla’s outstanding common stock. The Tesla board believed that offering Musk the opportunity to increase his stake in Tesla from 21.9% to up to 28.3% had no downside for stockholders. Musk would be incentivized to stay at Tesla and grow the business to unprecedented heights.
- The Tesla board approved the Grant on the condition that it be approved by a majority vote of the disinterested stockholders. At a special meeting held on March 21, 2018, the Grant was approved by 73% of disinterested stockholders (meaning votes cast in person or by proxy excluding the votes of shares owned, directly or indirectly, by Musk or his brother, Kimbal Musk).
- On June 5, 2018, a Tesla shareholder filed this derivative lawsuit in the State of Delaware, alleging breaches of fiduciary duties, unjust enrichment, and waste.
- As of June 30, 2022, all market cap milestones pertaining to the Grant, and three of the revenue milestones, had been achieved.
- On January 30, 2024, the Delaware Court of Chancery entered a judgment in the plaintiff’s favor, rescinding the Grant, sharply criticizing the Tesla board and compensation committee, and painting an unflattering portrait of Tesla’s corporate governance practices. The court’s opinion includes the following findings:
- The directors breached their fiduciary duties and, under an entire fairness standard of review, the defendants could not prove that the Grant was fair.
- The process by which the grant was developed and presented for approval was “deeply flawed.” Although Musk did not have voting control of Tesla on a purely mathematical basis, he had effective control. His superstar status as a CEO, a person who is uniquely valuable to the company, helped tilt the balance of power, with Tesla’s directors having a “controlled mindset.”
- Musk dominated the compensation process, including the timeline. There was no positional bargaining, with Musk testifying that he was in effect negotiating with himself. There was no standard benchmarking analysis. The court was highly critical of the board for questions it did not appear to ask. If the purpose of the Grant was to make sure Musk remained focused on Tesla’s business, why wasn’t the Grant conditioned on Musk satisfying minimum time and attention requirements? Why was additional incentive compensation of this magnitude necessary given how many shares Musk already owned, with each $50 billion incremental increase in Tesla’s market cap resulting in $10 billion in additional value for Musk?
- The compensation committee and the board did not act in Tesla’s best interest. Directors who were designated as independent by Tesla were not in fact independent, with many having amassed sizable fortunes either through compensation received as a Tesla director or investments in other Musk companies. For example, prior to the Grant, the chair of the compensation committee owned interests in companies controlled by Musk (other than Tesla) valued at $75 million. Another member of that committee held interests valued in excess of $1 billion in business entities controlled by Musk, which he said gave him “dynastic or generational wealth.”
- The stockholder vote, which was not required by the Delaware General Corporation Law but was required by NASDAQ, was not valid because stockholders were not fully informed. Tesla’s proxy statement did not disclose all material facts, including the degree to which Musk controlled the processes of the board and the compensation committee that resulted in the design and approval of the Grant. Actual or potential conflicts of interest between the directors and Musk were not disclosed. Descriptions of directors as “independent” were proven untrue, and such directors were actually beholden to Musk.
Neither Tesla nor the other defendants has announced whether the decision will be appealed to the Delaware Supreme Court.