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Summaries and analysis of recent Delaware court decisions concerning business-related litigation.
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Chancery Applies Entire Fairness Review to Executive Compensation Decision Benefiting Controller Despite Stockholder Approval, Declining to Dismiss Claims Involving Tesla’s Elon Musk
Under Delaware law, executive compensation decisions by a corporation’s board of directors generally are entitled to deferential judicial review, and even more so when approved by the stockholders. On the other hand, Delaware law generally imposes heightened scrutiny in the form of entire fairness review for transactions uniquely benefiting a corporation’s controlling stockholder, relying on the inherent coercion that accompanies control. So what standard of review applies when an executive compensation decision benefits the company’s controlling stockholder and the stockholders approve it?
It is a question of first impression under Delaware law and this opinion answers it while addressing the roughly $56 billion compensation package that Tesla recently awarded CEO Elon Musk. According to Tornetta v. Musk, an executive compensation decision benefiting an alleged controlling stockholder generally invokes stringent entire fairness review and stockholder approval alone will not reduce the standard to deferential business judgment review.
In January 2018, Tesla’s board of directors approved a performance-based compensation plan for Musk in his role as CEO, potentially valued at up to $55.8 billion, which the company’s stockholders also approved. A Tesla stockholder brought this action in the Delaware Court of Chancery against Musk and the board alleging breaches of fiduciary duties in connection with Musk’s compensation plan. Defendants moved to dismiss, arguing the board’s compensation decision was subject to deferential business judgment review and dismissal in light of the stockholders’ approval.
The Court of Chancery disagreed, finding the board’s compensation decision was subject to entire fairness review despite stockholder approval, rendering dismissal inappropriate. As the Court observed, under Delaware law, transactions in which the corporation deals with a conflicted controlling stockholder invoke heightened judicial scrutiny in the form of entire fairness review. The board’s compensation decision for Musk fell into that category and thus was subject to entire fairness review by default.
The Court went on to find that approval by Tesla’s stockholders was insufficient to reduce the standard of review from entire fairness to business judgment. By way of background, fully-informed and uncoerced approval of a board’s decision by the corporation’s disinterested stockholders generally will invoke business judgment review. But more is required to obtain business judgment review when a conflicted controller is involved, at least in the squeeze-out merger context. Under Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014) (“MFW”), a board can secure business judgment review of a conflicted controller transaction if it employs dual protections involving (i) an independent special committee and (ii) a majority-of-the-minority stockholder vote.
Here, after examining Delaware authority on controller transactions, including MFW, the Court determined that these rules extend to the executive compensation context. In reaching that conclusion, the Court declined to read MFW’s dual-protection requirement as applying only to “transformational” conflicted controller transactions where the Delaware General Corporation Law requires approval of both the corporation’s board and its stockholders. As the Court reasoned, relying on Delaware’s reflexive suspicion of conflicted controller dealings, a “controlling stockholder’s potentially coercive influence, is no less present, and no less consequential, in instances where the board is negotiating the controlling stockholder’s compensation” and “stockholder ratification, without more, does not counterpoise the risk of coercion[.]” Thus, according to the Court, a board wishing to obtain business judgment review for an executive compensation decision benefitting a controller needs to first employ and satisfy MFW’s dual protections.
Applying those principles to this case, where the board did not utilize MFW’s dual protections, the Court found that entire fairness review applied to the adoption of Musk’s compensation plan despite stockholder approval. With defendants having received the minority stockholders’ approval, the plaintiff bore the burden to sufficiently allege that the plan was unfair to Tesla. Reviewing the complaint, the Court found the plaintiff accomplished that, meaning dismissal was inappropriate.