This year a Delaware court declared in Tornetta v. Musk that the $56 billion pay plan Tesla gave to CEO Elon Musk was invalid because the shareholders weren’t properly informed about how it was negotiated by the board of directors. I think that was a mistake. The shareholders didn’t need information on the negotiations, just on the pay plan. The judge, Chancellor McCormick, cited a 2007 case, Sample v. Morgan, for why negotation details were important.1 The Chancellor misuses Sample, however. That pay plan was struck down because it was intentionally deceptive, and so unreasonable that no shareholder who really understood it would have voted for it.
First, let’s lay out the Tornetta case. Elon Musk was CEO of Tesla, and also the biggest shareholder, with 21.9% of the shares, and also one of the nine members of the board of directors. He proposed that his compensation as CEO take the form of a zero base salary and grants of more Tesla stock if Tesla’s stock value went up from its current level of $50 billion. If it went up to $99 billion or less, Musk would get zero. If it went up to $100 billion, he would get 1% more of the company’s stock to add to his 21.9%. If it went up $650 billion, he would get 6% more, worth $56 billion. That’s what happened (p. 6 of the post-trial opinion).
Musk didn’t vote on his own pay plan. The outside directors on the board approved it, and then the entire board of directors. They then submitted the pay plan to the shareholders, and the shareholders voted for it, amidst much public comment.
Mr. Tornetta sued, saying the pay plan hadn’t been properly approved. In particular, the shareholders had not been told that it was Mr. Musk who proposed the first draft rather than the Board coming up with the plan. Delaware Chancellor McCormick agreed and voided the whole pay plan, leaving Musk with zero pay for those yars.
Chancellor McCormick did not argue that Musk’s pay was too high. She would have allowed it if the shareholder vote had been done right. So what was wrong?
Chancellor McCormick noted that if the board of directors’ non-employee members were truly independent, free to vote for what was best for the company without fear of personal consequences, there would be no legal problem with the pay plan. She held, that they were not independent,2 so the “entire fairness” standard applied, and the board of directors had to let the shareholders vote on the plan. If this vote had been held with “entire fairness”, then the defendants (Tesla and Musk) would not have had to prove that the pay plan itself was fair. As the Chancellor put it:
Delaware law allows defendants to shift the burden of proof under the entire fairness standard where the transaction was approved by a fully informed vote of the majority of the minority stockholders. . .
The defendants were unable to prove that the stockholder vote was fully informed because the proxy statement inaccurately described key directors as independent and misleadingly omitted details about the process.
The defendants were thus left with the unenviable task of proving the fairness of the largest potential compensation plan in the history of public markets.
The shareholders were fully informed about the pay plan itself, and how much Musk would be paid if the stock price went from $50 billion to $650 billion. Rather, the problem was with this paragraph in the proxy statement given to voters to inform their vote:
With the 2012 Performance Award nearing completion, the Board engaged in more than six months of active and ongoing discussions regarding a new compensation program for Mr. Musk, ultimately concluding in its decision to grant the CEO Performance Award. These discussions first took place among the members of the Compensation Committee of the Board (the ‘Compensation Committee’), all of whom are independent directors, and then with the Board’s other independent directors, including its two newest independent directors, Linda Johnson Rice and James Murdoch.
Chancellor McCormick said,
The Proxy does not disclose the level of control that Musk exercised over the process—e.g., his control over the timing, the fact that he made the initial offer, the fact that his initial offer set the terms until he changed them six months later, the lack of negotiations, and the failure to benchmark, among other things.
Also,
Musk proposed a grant size and structure, and that proposal supplied the terms considered by the compensation committee and the board until Musk unilaterally lowered his ask six months later.
and
The committee avoided using objective benchmarking data that would have revealed the unprecedented nature of the compensation plan.
So, the problem was in describing the background to the pay plan, not in the description of the pay plan itself. But should the background matter, if the stockholders understand the pay plan anyway? Yes, Chancellor McCormick said, citing a precedent:
In fact, then-Vice Chancellor Strine rejected as “frivolous” the argument that “the only material facts necessary to be disclosed” regarding a stock incentive plan are the “exact” economic terms of the plan.[footnote 776]
Footnote 776 says
776. Sample v. Morgan, 914 A.2d 647, 652, 663–67 (Del. Ch. Jan. 23, 2007) (rejecting the “frivolous” argument because stockholders would also want to know where the plan originated, the self-interested purpose of the plan by those who conjured it up, and information regarding the comparative size of the plan to other corporate equity plans).
I think this mispresents Sample. In Sample, where the plan originated is not important, though what the originators were saying to each other was, because it showed their intent to deceive in the way they constructed the plan, a plan so wasteful that shareholders would not have approved had they understood it. If the pay plan had been reasonable and transparent, Vice Chancellor Strine would have upheld it even if the origination process had not been described.
To see why I think that, let’s look at the facts of Sample. In Sample, the board of directors asked the shareholders to vote on issuing new stock to use for compensation of company employees.
Once issued, those 200,000 shares would account for nearly a third (31.7%) of the company's voting power going forward. The stockholders were told that the decision as to which employees would receive the shares and under what terms and conditions would be made by a committee of non-employee directors.
The same day as the stockholder vote, the board formed a Compensation Committee to consider how to implement the Incentive Plan. At its very first meeting, which lasted only 25 minutes, the two member Committee considered a proposal by the company's outside counsel to grant all 200,000 shares to just three employees of the company — the CEO, the CFO, and the Vice President of Manufacturing — all of whom were directors of the company and who collectively comprised the majority of the company's five member board.
Soon thereafter, the Compensation Committee decided to cause the company to borrow approximately $700,000 to cover the taxes owed by the Insider Majority on the shares they received.
The phrasing of the proxy statement gave the impression that the pay plan was to attract and retain key employees in general, not that the two outside members of the Board would, in a single 25-minute meeting, give the entire amount to the three insider members— and then add to the pay plan by paying the insider’s taxes. Ex post, it is clear the intent was to give a third of the stock to the CEO, the CFO, and the Vice President of Manufacturing. In that case, why not name them in the proxy statement, rather than set up a Compensation Committee? The obvious answer is that the Board wished to deceive the shareholders. As Vice Chancellor Strine said in the key paragraph of his opinion:
In this opinion, I deny this frivolous motion to dismiss. The complaint plainly states a cause of action. Stockholders voting to authorize the issuance of 200,000 shares comprising nearly a third of the company's voting power in order to "attract[ ] and retain[ ] key employees" would certainly find it material to know that the CEO and company counsel who conjured up the Incentive Plan envisioned that the entire bloc of shares would go to the CEO and two other members of top management who were on the board. A rational stockholder in a small company would also want to know that by voting yes on the Charter Amendment and Incentive Plan, he was authorizing management to receive the only shares that the company could issue during the next five years due to a contract that the board had simultaneously signed with the buyer of another large bloc of shares.
What is material here is not the process by which the directors came up with this scheme, but their “vision” of what it would do, a vision they carefully obscured. The pay plan was (a) designed in a purposely obscure way whose only purpose was to deceive shareholders, and (b) was so crazy that no rational stockholder would approve it if he understood it. On point (b), Vice Chancellor Strine says that the plan was so bad that it may have reached the legal standard for “waste”, subjecting all the directors to liability:
Although the test for waste is stringent, it would be error to determine that the board could not, as a matter of law, have committed waste by causing the company to go into debt in order to give a tax-free grant of nearly a third of the company's voting power and dividend stream to existing managers with entrenchment motives and who comprise a majority of the board in exchange for a tenth of a penny per share.
Compare this with Elon Musk and Tesla. The Musk pay plan was straightforward and transparent. It didn’t simply give away stock to Musk as was done in Sample; it paid him only if he achieved dramatic increases. His potential for enormous compensation— if the company had enormous profits— was obvious. Any shareholder who couldn’t understand would find numerous articles in the media discussion the pros and cons of the plan, since the plan was so unusual and Tesla was such a big company. In Sample, on the other hand, we have a pay plan written to deceive, and a company too small to get attention and debate from the media and from stock analysts.
Chancellor McCormick, however, picked up on other complaints about the company that Vice Chancellor Strine wrote in his opinion, complaints not essential to his holding. The holding in that key part of the opinion, quoted above, is that the purpose of the plan, to enrich the top three managers, was concealed and if the shareholders had understood what the plan really meant, they clearly would have voted it down. Note, in particular, that the wrongdoing is not that the CEO and outside counsel came up with the plan, but that it was a bad plan deceptively presented. Shareholders “would certainly find it material to know that the CEO and company counsel who conjured up the Incentive Plan envisioned that the entire bloc of shares would go to the CEO and two other members,” not, “would certainly find it material to know that the CEO and company counsel conjured up the Incentive Plan.”
Vice Chancellor Strine was not concerned about the process, except insofar as the process shows intent to deceive by the fact of meetings as to how best to construct an extravagent pay plan that would fool the shareholders. Process is relevant only because it reveals a conspiracy to obfuscate the pay plan’s presentation.
The complaint notes that the directors failed to disclose that the Charter Amendment and Incentive Plan had resulted from planning between the company's outside counsel — the same one who eventually served as the sole advisor to the committee that decided to award the entire 200,000 shares to the Insider Majority at the cheapest possible price and with immediate voting and dividend rights — and the company's CEO. In memoranda to the CEO, the company's outside counsel articulated that the Incentive Plan was inspired by the Insider Majority's desire to own "a significant equity stake in [Randall Bearings] as incentive for them to grow the company and increase stockholder value, as well as to provide them with protection against a third party . . . gaining significant voting control over the company."
and
Critically, the Boeckman Memos also contain an allocation plan that suggests that it was contemplated from the get-go that all of the shares authorized by the stockholders would be granted to the Insider Majority. That the Amendment and Plan had their origin in this type of planning would clearly be of relevance to a reasonable investor.
Let’s go back to what Chancellor McCormick said:
The Proxy does not disclose the level of control that Musk exercised over the process—e.g., his control over the timing, the fact that he made the initial offer, the fact that his initial offer set the terms until he changed them six months later, the lack of negotiations, and the failure to benchmark, among other things.
She then said
Then-Vice Chancellor Strine rejected as “frivolous” the argument that “the only material facts necessary to be disclosed” regarding a stock incentive plan are the “exact” economic terms of the plan.
But look what Vice Chancellor Strine said was that although shareholders were told the exact terms of the plan, they were misled as to the implication of those terms. The outrageous behavior of the directors was to follow the letter of the pay plan but to pay out the funds in a way the shareholders didn’t expect— to three directors rather than to “attract” employees. Strine is saying that a proxy statement cannot rely on being literally true if it presents the facts in a purposely misleading way, a way such that shareholders would be fooled into voting for a pay plan that they would reject if it were presented to them fairly. Vice Chancellor Strine is not saying that the shareholders needed to understand where the pay plan came from, just that they needed to understand what it said, and where it came from could shed light on whether it was purposely misleading.
In Tornetta, on the other hand, Chancellor McCormick says that what the proxy should have revealed was that Musk made the first offer, that six months later he made concessions, that there wasn’t a lot of back and forth negotiation, and that the board didn’t benchmark by comparing the pay plan with other companies. None of that goes to an intent to come up with a plan that would fool shareholders. And if the plan is clear, with abundant public debate over its provisions, why should these things matter?
Making the first offer in bargaining is not a sign of power. Car dealers want customers to make the first offer, so they can take advantage of poorly informed customers. A board may well ask a CEO what he wants from a pay plan, either formally or informally. That Musk made concessions, or that the negotiations were mostly over minor details, does not tell us that the pay plan was too generous. Lack of benchmarking is only to be expected— what conceivable good could it do to hire a consulting firm to tell the board what CEO’s like Musk are paid, whether are no other CEO’s like Musk?
Would these procedural details have made a difference in Sample? There, it seems it was the outside counsel who came up with the pay plan— though no doubt at the request of members of the board. The non-employee directors could have created the scheme— but they were the ones who formed the Compensation Committee that gave away the shares. An outside consultant could have been hired to validate the use of stock to motivate key employees by use of a compensation committee— but that in itself is not the problem, and a consultant willing to give the desired answer could no doubt be found. No, the problem in Sample was, as I have said, that the the scheme was written to deceive and that the true plan was outrageously generous to the managers.
Thus, Chancellor McCormick made bad use of Sample. Sample’s holding was not that the Board must make the first offer, or that there must be a certain level of haggling in the creation of a plan. Rather, it was that the plan itself must not be presented in a way calculated to deceive, and that evidence of such deception would include memos from the deceivers and that any rational shareholder who really did understand the plan would not have voted for it. The Tornetta case has none of those features. The effect and purpose of the plan was clear— to reward CEO Musk heavily if the stock price doubled or more and to give him zero otherwise. There are no memos saying that the plan was created and described as a way to conceal a giveway. And rational people could disagree as to whether it was a good plan or not.
Thus, I hope Delaware’s Supreme Court would reverse Tornetta. Not only does it treat Tesla and Musk badly, but it would set a precedent for people to sue companies merely because of surface procedures easy for dishonest directors to follow, not because of genuine fraud.
Sample v. Morgan, 914 A.2d 647 (Del. Ch. Jan. 23, 2007), which Chancellor McCormick cites in footnote 776 of Tornetta v. Musk et al., post-trial opion Delaware Court of Chancery, C.A. No. 2018-0408-KSJM (January 30, 2024).
What “independent” means depends on the context. In its proxy statement, Tesla went with the formalistic NASDAQ regulatory definition:
Currently, the Compensation Committee consists of four members of our Board: Brad Buss, Robyn Denholm, Ira Ehrenpreis and Antonio Gracias, none of whom is an executive officer of Tesla, and each of whom qualifies as (i) an “independent director” under the NASDAQ Stock Market Rules and (ii) an “outside director” under Code Section 162(m).
For the purposes of a court deciding whether the directors are going to personally gain from the way they vote (or to lose, from the spite of other directors), the NASDAQ definition is just a starting point. Thus, McCormick devotes much of the opinion to explaining why she holds that the key directors were not independent.
“ He proposed that his compensation as CEO take the form of a zero base salary and grants of more Tesla stock if Tesla’s stock value went up from its current level of $50 billion. If it went up to $99 billion or less, Musk would get zero. If it went up to $100 billion, he would get 1% more of the company’s stock to add to his 21.9%. If it went up $650 billion, he would get 6% more, worth $55 billion. That’s what happened (p. 6 of the post-trial opinion).”
So, if I understand this correctly, Musk proposed that if the market cap increased the value of shareholders’ stock by 1,300%, he would increase the number of share he held by ~33%. And someone in a position of authority found fault with this. It will be interesting to see what SCOTUS has to say about this. And the date that he moves Tesla from Delaware to Texas.