12 February 2024 Elon Musk and the Delaware Court

Full Disclosure:​

Elon Musk and the Delaware Court​

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Hi Reader 👋🏽,

The Story: It’s 2018 and Richard, an unhappy Tesla shareholder, brings a ‘derivative claim’ against Elon and other directors. This type of claim is uncommon; normally companies bring claims, but in this case, Richard is bringing a lawsuit on behalf of the company (‘you didn’t take action, so I will’).

In a public company, the board of directors help to set company policy, like how much the CEO gets paid. They have what we call ‘fiduciary duties’ to act in the best interests of the company and its shareholders.

Richard claims that Tesla’s directors breached their fiduciary duties when Elon was offered his new pay package in 2018 - the highest compensation package to a CEO in the history of public markets.It was performance-based, requiring Elon to grow Tesla’s market cap from $100bn to $650bn, alongside operational targets, if he wanted to unlock every tranche of the package.

The Legal Issues: The judge in the Delaware court ruled in favour of Richard. She found that the directors breached their fiduciary duties. Elon’s pay package was voided, even though it was approved by the board and shareholders. Let's look at how she made her decision:

1. Normally the courts will defer to the business judgement of the board. BUT because Elon Musk had effective control over Tesla, the judge applied the strictest standard under Delaware law called the ‘entire fairness’ standard. Therefore, the burden was on Elon and the directors had to prove the compensation plan was ‘entirely fair’.

2. Delaware law normally allows the burden of proof to shift to the plaintiff/claimant where there is director/shareholder approval. BUT this was not possible in this case, because the judge found a) the directors weren’t independent and b) the shareholders weren’t sufficiently informed of this fact. Half the board was ruled to be effectively puppets to Elon, they had decade-long relationships, vacationed together, and one was even Elon’s former divorce lawyer.

3. The judge found that the defendants did not prove the grant was entirely fair. There were two grounds to establish fairness here, fair process and fair pay. Given Elon first proposed the terms, set the timeline, and there was no serious negotiation, the judge found the process was not fair. And given that the board failed to consider whether Elon even needed this huge pay to be incentivised, the judge found the pay was not fair.

4. The judge granted ‘rescission’, which is a remedy that seeks to put the parties in a position they would have been in prior to the contract. The judge found this was a suitable remedy given Elon’s options had not been exercised yet.

Unsurprisingly Elon is unhappy that a judge could revoke an enormous pay package that was otherwise approved by the board of directors and Tesla's shareholders.

Impact on Law Firms: More than 60% of the largest 500 companies in the US incorporate in the state of Delaware. It's seen as business-friendly, with a well respected judicial system. In this case, the judge was from the Court of Chancery, one of the oldest courts in the US, with substantial experience in corporate law. But, since the decision, Elon has been threatening to re-incorporate in Texas, which is in the process of creating its own business courts. Could this be a threat to the reputation of Delaware as the choice for US businesses? Unlikely. It wouldn't be the first time Elon has threatened to do something without taking action.