ML BeneBits

In a case of first impression, the Delaware Court of Chancery has held that the entire fairness standard of review applies to compensation decisions made with respect to controlled companies, absent implementation of specified protections.

On September 20, 2019, Vice Chancellor Joseph Slights of the Delaware Court of Chancery denied a motion by Tesla, Inc. (Tesla) to dismiss a shareholder lawsuit (Tornetta v. Musk et al., case number 2018-0408) challenging the approval of a 10-year incentive-based compensation plan for Tesla’s Chief Executive Officer Elon Musk (the Award). The Award, which was approved by an independent compensation committee of Tesla’s Board of Directors and thereafter ratified by a majority of the minority of Tesla’s stockholders, provides Musk with the opportunity to earn performance-based stock options that, if fully realized, would be valued at approximately $55 billion.[1] A minority stockholder filed both direct and derivative claims against Musk and the Tesla board, alleging that the Award is excessive and is the product of breaches of fiduciary duty. In response to the derivative suit, Tesla filed a motion to dismiss, which required Vice Chancellor Slights to address the “gating question that frequently dictates…a breach of duty claim: under which standard of review will the court adjudicate the claim?” Determining that the “entire fairness” standard—rather than the business judgment rule—should be applied absent implementation of the “dual protections” of Kahn v. M & F Worldwide Corp., 88 A.3d 635, 642 (Del. 2014) (M&FW), the court refused to dismiss the complaint, in a ruling that marks a major shift in Delaware case law.

Historically, the Delaware Court of Chancery has deferred to the board of directors’ judgment on matters of executive compensation, applying the deferential business judgment rule standard of review. E.g., Brehm v. Eisner, 746 A. 2d 244 (Del. 2000) (“[A] board’s decision on executive compensation is entitled to great deference”). That same deferential standard has been applied even when the recipient of the compensation is a controlling stockholder, so long as the compensation decision was made by an independent compensation committee. E.g., Friedman v. Dolan, 2015 WL 4040806 (Del. Ch. June 30, 2015).

A year after Dolan was decided, however, Vice Chancellor Travis Laster disagreed with Dolan’s conclusion, reasoning that the weight of Delaware authority required the application of entire fairness review in any instance where a controlling stockholder obtains a benefit distinct from that provided to the other stockholders. In re Ezcorp Inc. Consulting Agreement Derivative Litigation, 2016 WL 301245, at *20 (Del. Ch., 2016) (“the entire fairness framework governs any transaction between a controller and the controlled corporation in which the controller receives a non-ratable benefit.”). In dicta, the Ezcorp decision did identify a potential avenue to business judgment review for controlling stockholders – implementing the two structural protections for minority stockholders articulated in M&FW. In M&FW, the Delaware Supreme Court held that transformational transactions (e.g. a squeeze out merger) that disproportionately benefit a controlling stockholder may be subject to the deferential business judgment standard of review where the transaction is conditioned from the outset—ab initio—upon the “dual protections” of (1) being negotiated by an independent special committee, and (2) subsequent approval by a fully informed vote of the “majority of the minority” of disinterested stockholders. Significantly, in Tornetta, Vice Chancellor Slights assumed for the purposes of the motion to dismiss that a majority of Tesla’s compensation committee that approved the Award “was not independent of Musk’s influence,” and that there lacked a basis on which to conclude that the stockholder vote approving the Award would not be subject to “inherent” coercion.

Tornetta is an important decision for several reasons. First, it sides with Ezcorp over Dolan, rejecting the deferential business judgment standard of review for controlling stockholder transactions when the only protection afforded to the minority stockholders is the use of an independent committee. As Vice Chancellor Slights reasoned, 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 than it is when the board is negotiating with the controller to effect a ‘transformational transaction’.”

Second, Tornetta extends the opportunity for controlling stockholders to obtain the deferential business judgment standard of review for executive compensation decisions by employing the dual protections of M&FW, which are that the compensation is conditioned from the outset—ab initio—upon the “dual protections” of

• Being negotiated by an independent special committee; and
• Subsequent approval by a fully informed vote of the “majority of the minority” of disinterested stockholders.

The Tornetta decision is also notable due to the significance of process and timing. The court held that the defendant’s proper execution of statutory ratification by the stockholders was insufficient to overcome entire fairness, as the compensation was not conditioned at the outset on an affirmative vote of the majority of the minority of disinterested shareholders.

The court’s refusal to grant Tesla’s request to dismiss the lawsuit and its application of the higher judicial standard marks a substantial shift in the review of executive compensation decisions for controlled companies under Delaware law. Tornetta also will likely have strong persuasive value for courts outside Delaware.

Please contact the authors or your Morgan Lewis contacts if you have any questions about the importance and impact of the Tornetta decision.