Implications of Tornetta v. Musk II for Executive Compensation and for Stockholder Ratification

In Tornetta v. Musk (Jan. 30, 2024, "Tornetta I"), the Delaware Court of Chancery ordered rescission of the 10-year equity compensation plan for Elon Musk (Tesla, Inc.'s chief executive) that had been approved by Tesla's board and the stockholders unaffiliated with Musk. Under the plan, Musk was awarded several tranches of performance-vesting stock options, with an estimated value of approximately $56 billion (now worth about $100 billion based on Tesla's current stock price). All of the stock options had vested, as Tesla met all of the growth objectives specified in the plan, but Musk had not exercised any of the options. The court's decision eliminated all of the compensation provided for under the plan.

Following Tornetta I, Tesla provided to the stockholders additional disclosure about the compensation plan and the court's decision, and the stockholders unaffiliated with Musk again approved the same plan, for the stated purpose of ratifying it. Tesla then requested that, in light of the stockholders' ratification, the court revise its decision to rescind the plan. In the most recent decision in the case (Dec. 2, 2024, "Tornetta II"), the court rejected the request to revise its decision rescinding the plan.

Key Points

• The Tornetta decisions have been controversial-but, in our view, should be read with the specific context in mind. Some have viewed the decisions as reflecting the court's substitution of its own judgment for that of Tesla's board and stockholders as to the appropriate compensation for Musk. In our view, much of the court's reaction and reasoning in these decisions flowed from the unique combination of the extraordinary amount of the compensation together with the apparently extraordinary control Musk had (at least with respect to the compensation plan). We query whether the court may have had a view-albeit unstated-that it is simply not conceivable that pay of $56 billion could be appropriate for any chief executive at any company under any circumstances. (Of course, what the court viewed as a flawed approval process by Tesla contributed to the judicial result-see "Our Observations" below.)
  
  
• What does Tornetta mean for future executive compensation cases? Generally, executive compensation is an area in which the Delaware courts are highly deferential to board decisions-as compensation is a quintessentially business decision. We note that many CEOs are granted very high levels of compensation and significant equity-based incentives without any problem. While in this case the court found fault with the process for determining Musk's compensation package and with the disclosure provided to the stockholders about the process, in our view the court's opinion may suggest (although the court did not state as much) that there may be some "Superstar CEOs" who have so much influence and control over the company's board and stockholders that, as a practical matter, it may not be possible to consider the directors approving compensation for such a CEO to be independent nor to consider the unaffiliated stockholders approving compensation for such a CEO to be fully informed and uncoerced. In other words, it may be that, in such a context, the court will be much more skeptical as to the independence, process and disclosure issues than would otherwise be the case, and may always, or almost always, apply the entire fairness standard of review.
  
  
• What does Tornetta mean for future stockholder ratification cases? Generally, common law stockholder ratification of board action has the effect of invoking business judgment rule deference to the board, thus protecting the action from fiduciary challenges (other than for corporate waste). Tornetta II, however, establishes a boundary on the use of stockholder ratification-the court held that stockholder ratification of a board action will not be effective to shield directors from liability for fiduciary breaches if the ratification comes after issuance of a post-trial judicial decision rejecting the board's action on the basis of such breaches. Importantly, the court indicated in Tornetta II that this would be the result even where the board's action was approved by independent directors and the stockholders' ratification vote was fully informed and non-coerced.

Background. Tesla's compensation committee (comprised of purportedly independent directors), and Tesla's board (comprised of purportedly independent directors plus Musk and his brother), and the Tesla stockholders unaffiliated with Musk, approved a compensation plan for Musk after a 9-months long period, with the compensation committee having met formally at least ten times. A stockholder-plaintiff brought suit challenging the plan. In Tornetta I, Chancellor Kathaleen St. J. McCormick found that Musk had controlled the board's process for determining his compensation and the plan therefore was a conflicted-controller transaction. As such, the plan was subject to entire fairness review unless the MFW prerequisites were satisfied. The Chancellor found that neither of the MFW prerequisites were not satisfied-the directors who approved the plan were not independent of Musk, and the stockholder vote was not fully informed. Therefore, entire fairness applied, with the burden of proof on Tesla to prove that the process and amount of the compensation were fair to the corporation and its stockholders. The Chancellor, finding that Tesla failed to meet that burden of proof, ordered rescission of the entire compensation plan. (See the Fried Frank M&A/PE Briefing on Tornetta I: Chancery Finds Tesla Board Breached Fiduciary Duties.)

Immediately after Tornetta I was issued, Musk and Tesla publicly criticized the decision. Also, Musk announced in a series of tweets that he intended to cause Tesla to reincorporate under Texas law, and that he might divert Artificial Intelligence and robotics away from Tesla. Tesla tasked the one-person independent special committee that was considering the reincorporation to consider also whether the same compensation plan should be submitted to another vote of the unaffiliated stockholders for the purpose of ratifying it. The committee determined that the company should reincorporate in Texas (which the company did), and that the compensation plan should be submitted to the stockholders for ratification. Tesla provided the stockholders with additional disclosure relating to the compensation plan, the Tornetta I decision, and the effects of stockholder ratification; and the stockholders overwhelmingly voted to ratify the plan. Tesla then requested that, in light of the stockholder ratification, the court revise its decision rescinding the compensation plan. In Tornetta II (Dec. 2, 2024), the Chancellor rejected revising the decision to rescind the plan. The Chancellor also awarded plaintiff's counsel a fee of $345 million (a Delaware record).

Certain Tesla stockholders have filed an appeal of both Tornetta decisions.

Discussion

The court stressed the unique factual context. At $56 billion (now worth $100 billion), the compensation package for Musk was not just unusually large but truly extraordinary. The court noted that the plan was 250 times larger than the contemporaneous median peer compensation plan, and over 33 times larger than the closest comparison (Musk's own prior compensation plan). The compensation plan was "the largest, by multiple orders of magnitude, ever awarded in the history of public markets," the court wrote. In addition, the perceived level of Musk's control over Tesla was extraordinary. The court viewed "a unique suite" of factors as clearly establishing Musk's control (at least over the decision-making process for his compensation). These factors included his then 21.9% stock ownership (particularly in combination with the company's supermajority vote requirement for bylaw amendments); his "total" control over management; his having often acted without board oversight or approval; and his general status as a "Superstar CEO" to whom everyone deferred. Further, the court concluded that the record demonstrated that Musk had proposed the compensation plan, and then had controlled both the timing of the process and the terms of the plan. The court stressed that Tesla directors had testified that they viewed the compensation process as a cooperative one with Musk, and not adversarial, because they wanted Musk to be happy with his compensation package. That testimony, the court stated, "[came] as close to admitting a controlled mindset as it gets."

The court rejected revising its decision to rescind the compensation plan, notwithstanding the stockholder ratification. The court cited four reasons, each of which alone, it stated, provided a sufficient basis for not revising its decision to rescind the plan: (i) there is no procedural basis on which the outcome of an adverse post-trial opinion can be undone by a stockholder vote; (ii) common-law stockholder ratification is an affirmative defense, and as such cannot be raised for the first time after a post-trial opinion; (iii) a stockholder vote standing alone cannot ratify a conflicted-controller transaction; and (iv) the ratification vote was not fully informed.

The court emphasized the negative policy and practical implications of revising a post-trial decision based on stockholder ratification obtained after the decision has been issued. The court characterized the ratification by Tesla's stockholders as "newly created evidence"-that is, "evidence not in existence at the time of trial…[that the] [d]efendants created…after the Post-Trial Opinion" was issued. While there are rules governing the admissibility, during a trial, of "newly discovered evidence"-that is, "evidence in existence at the time of trial but hidden or unknown" until discovered at some point during the trial-there is no basis for submitting, after the trial is over, newly created evidence. Moreover, the purpose for which the defendants sought to introduce the new fact of the ratification vote was to "flip[] the outcome of the Post-Trial Opinion." The court wrote: "Were the court to condone the practice of allowing defeated parties to create new facts for the purpose of revising judgments, lawsuits would become interminable…. Defendants' version of 'common law ratification' would allow a party found liable for fiduciary misconduct to deploy stockholder ratification to reverse the effects of a court finding long after that litigation is final." In this case, the court noted, the defense of stockholder ratification was raised six years after the case was first filed, eighteen months after trial, and five months after the post-trial opinion was issued.

The court held that the stockholder ratification could not cleanse the rescinded conflicted-controller transaction. Delaware law recognizes (i) "statutory" (or "legal") stockholder ratification-which "allows stockholders to bestow legal authority on a corporate act in circumstances in which the agent [who acted for the stockholders] had no authority or arguably had no authority at the time he acted" or the act was void (as codified in DGCL Section 204); and (ii) "common law" (or "fiduciary") stockholder ratification-which "allows stockholders to express, through an affirmative vote, their view that a corporate act is consistent with [stock]holder interests."

The Defendants, in Tornetta II, relied on fiduciary ratification. The court clarified that the effect of fiduciary ratification varies depending on the context-if the stockholder vote is fully informed and uncoerced, it may be a compete defense, change the standard of review, shift the burden of proof under the standard of review, or have no effect. In a context where "conflicts threaten the decision-making process," Delaware courts have limited the effect of a stockholder vote. "Just as the standard of review increases as conflicts become more direct and serious, the effect of fiduciary ratification diminishes." In the context of a conflicted-controller transaction (such as Musk's compensation), as the Delaware Supreme Court recently confirmed in Match Group (2024), the court applies entire fairness review; business judgment review will apply instead only if the MFW prerequisites were satisfied (including upfront approval by an independent special committee and by the minority stockholders in a fully-informed and uncoerced vote); and, if either such board approval or stockholder approval (but not both) were obtained, the burden of proof under entire fairness shifts from the defendants (to prove fairness) to the plaintiffs (to prove unfairness).

Here, the transaction did not comply with MFW, at a minimum because the stockholder ratification vote did not come until after the court's rescission of the compensation plan. The court rejected the defendants' argument that implementing the MFW protections before the ratification vote was sufficient. The court wrote: "One does not 'MFW' a vote, which is part of the MFW protections; one 'MFW's a transaction. If one could comply with MFW by submitting a rescinded transaction to a second, later vote, then the 'up-front precondition' requirement of MFW would have little meaning, and MFW would fail to fulfill its central objective," the court wrote.

The court also held that the ratification vote was not fully informed, as the disclosure about the effect of ratification was materially false or misleading. The court described the disclosure to stockholders as indicating that their ratification of the compensation plan would be "a powerful elixir," absolving the directors of any fiduciary breaches and restoring the rescinded stock options to Musk. The court stated, however, first, that, given that the entire fairness standard applied, stockholder ratification-even if it had been effective-at most would have just shifted the burden of proof on establishing fairness; and, second, as evidenced by the decision the court was rendering, ratification would not necessarily restore the stock options to Musk. Of note, Tesla's disclosure had included a statement that the court might find that the ratification was not fair to the stockholders or was otherwise legally invalid-but the court found that this caveat did "not correct the total mix of information nor temper Tesla's presentation of ratification as a comprehensive cure-all."

The special committee was not charged with considering the fairness of the compensation plan, just whether the plan should be put to a vote of stockholders to ratify it. The special committee (as noted, comprised of a single director) concluded that the plan should be put to a vote for ratification. The committee's primary reason for so deciding was that ratification would preclude Tesla's reincorporation to Texas from being wrongly perceived as having been made in direct response to the Tornetta I opinion and with the intent to award Musk compensation in a different jurisdiction that he could not get in Delaware. Other reasons included that, with ratification, the company could avoid the time and expense of putting together, and negotiating with Musk, a new compensation plan; and that, by not adopting a new plan, the company could avoid a potential accounting charge in excess of $25 billion. Notably, the committee was not charged with considering, and did not consider, the fairness of the compensation plan.

Our observations:

Size of the pay package. A compensation package for a chief executive providing stock options worth $56 billion (now $100 billion) understandably may simply shock the conscience. At the same time, however, we note that Musk, over just six years, grew Tesla by a truly extraordinary amount-$600 billion of growth, reflecting a thirteen-times growth in market capitalization. The compensation plan would have provided him with an additional 6% of the company's equity. Exchange of a 6% equity interest for $600 billion of growth is a deal that the Tesla stockholders, even after being informed of the court's concerns and objections, indicated they wanted-and, we surmise, might be a deal that stockholders at most companies would readily embrace.

Musk's equity stake as providing sufficient compensation. The court viewed Musk's then 21.9% equity interest in the company as potentially sufficient to retain and incentivize Musk as chief executive, without any grant of additional equity or other compensation. "After all," the court wrote in Tornetta I, given this equity stake, "he stood to benefit by over $10 billion for every $50 billion increase" in Tesla's growth. The court noted several other Superstar CEOs (such as Zuckerberg, Bezos and Gates), with significant equity stakes in their companies, who on that basis have foregone additional compensation for their efforts as CEO. As a general matter, however, it would seem at least arguable that a chief executive (or other key executive officer), irrespective of his or her equity stake in the company, could reasonably expect compensation for his or her efforts as the chief executive-who, unlike a major equity investor, makes day-to-day decisions for the company and is in charge of its operations.

Non-independence of the board. First, certainly, independent analysis of the reasonableness of a compensation package for an executive, and objective review of its fairness to the company and its stockholders, should be part of the process. However, one might question the court's conclusion that a board's decision to work on a cooperative, rather than an adversarial, basis with a highly valued chief executive, and a board's wanting such an executive to be happy with his compensation package, are proof-positive of a "controlled mindset." Second, although the court found there were "thick ties" between Musk and the directors such that their independence was in question, and in Tornetta I the court stressed the failure to disclose the directors' non-independence as the basis for its holding that the initial stockholder approval of the plan was ineffective, we note that the stockholders, at least when ratifying the compensation plan after the issuance of Tornetta I, could not then have been under any misimpressions with respect to the directors' independence, yet nonetheless overwhelmingly approved the compensation plan.

Practical impact of post-trial ratification. The court's holding in Tornetta II on stockholder ratification seems compelling-that is, that once the court reaches a post-trial judgment, it is impractical to permit defendants to engage in a workaround to the court's decision by "creating new facts" such as stockholder ratification of the same action the court had struck down. We query, however, whether the holding is equally compelling in all circumstances. It certainly makes sense in the context of a post-trial decision in which the court, say, finds damages in connection with an already-closed merger transaction (which cannot be easily unscrambled). But does it equally make sense in the context of a post-trial decision on compensation, at least where, as in this case, the awarded stock options have not been exercised? Although there may be tax and accounting implications for the company and/or the executive, there seems to be less reason to reject the will of the stockholders in this context. Arguably, once the stockholders are fully informed, their ratifying the same pay package as the court previously struck down would be the equivalent, in terms of honoring the stockholders' will, of their approving a new package, whether with the same or different terms.

Disclosure with respect to ratification. Tesla disclosed to stockholders that their ratification of the compensation plan would cleanse director fiduciary breaches in connection with the directors' having approved the plan-in other words, by ratifying the plan, stockholder would lose the right to bring fiduciary claims against the directors. The court held in Tornetta II that this disclosure was materially false, as ratification at best could have only had the more limited effect of shifting the burden of proof on fairness of the plan. We note that Tesla's disclosure thus conveyed to the stockholders that they had more to lose by ratifying the plan than the court viewed as actually being the case. While the court viewed the disclosure as materially false, it was materially false in a way that provided more reason for the stockholders to vote against the ratification, not to vote for it. One may question, then, why that disclosure was a basis for rendering the stockholder ratification ineffective.

In addition, we note that Tornetta II reflects a conundrum with respect to disclosure of the effect of stockholder votes (or the disclosure of other legal principles). Under the reasoning in Tornetta II, the court, by ruling at odds with the disclosed legal conclusions (even if they are caveated to warn that the court might rule differently), will automatically render the disclosure to stockholders false or misleading-with all the important consequences for standard of review and burden of proof that flow from a finding of materially flawed disclosure.

What happens next. If the Delaware Supreme Court upholds the Tornetta decisions, it may be that Tesla's board and stockholders will approve a new compensation plan for Musk. Tesla may or may not grant Musk equivalent incentive awards in the new plan as under the rescinded plan, and may or may not engage in a different process to try to address the aspects of the old process that the court viewed as problematic. Given Tesla's reincorporation to Texas, a new plan, if challenged, would be reviewed in the Texas Business Court, not the Delaware courts. If the Delaware Supreme Court does not uphold the Tornetta decisions, the case may be remanded to the Court of Chancery for further fact-finding proceedings relating to factual issues that the court did not address in its opinions given its holdings (such as, for one example, whether the ratification vote was coerced).

A challenge in Texas to a new compensation plan for Musk would raise certain interesting issues. First, Tesla has argued, and disclosed to its stockholders in connection with the reincorporation, that Texas imposes fiduciary duties that are equivalent to those imposed under Delaware law. Query, then, whether Tesla would be foreclosed from arguing in the Texas court that the Texas law permits compensation that Delaware did not permit? Also, if the Texas court upholds a compensation package that is equivalent to what Delaware struck down, without Tesla having engaged in a different process, then the disclosure Tesla made to its stockholders (that Texas's fiduciary standards are similar to Delaware's) arguably might be untrue. Finally, the Court of Chancery held in TripAdvisor (2024) that reincorporation from Delaware to a state with lower fiduciary standards is subject to entire fairness and can only be entirely fair if compensation is provided to the stockholders for the diminution in their "litigation rights" with respect to fiduciary breaches. Thus, a Texas decision upholding compensation that Delaware struck down (thereby indicating a diminution in the stockholders' litigation rights) may be disadvantageous to Tesla in connection with a challenge to its reincorporation to Texas.

Practice Points

• Board process for determining executive compensation for a controller. Tornetta indicates that a compensation committee and board should:
  
  • approach crafting the compensation package based on what compensation is "necessary" to meet the board's objectives in retaining and incentivizing the controller-executive;
  • actively negotiate the compensation package-that is, push back on, or propose counter-offers to, compensation terms that the controller-executive proposes;
  • do not, and do not appear to, simply capitulate to the controller-executive's wishes (possibly, even if the board views them as reasonable);
  • consider seeking analysis and opinion of an independent third-party compensation expert as to the fairness of the compensation, particularly in connection with a high level of compensation;
  • even in a unique situation, consider market-based factors when setting the compensation, including a traditional benchmarking study;
  • do not permit the executive-controller to dominate the process, and avoid any appearance of such domination-including with respect to the timing of the process and the terms of the compensation (and it may be preferable that the executive not be the one initially proposing the compensation);
  • consider to what extent (if any) an executive's equity ownership-at least if significant-may itself provide an incentive to the executive; and
  • tie the board's compensation decisions to the board's objectives (for example, the court noted that, while Tesla's directors contended that the extraordinary level of compensation was required to incentivize Musk to continue to focus his attention on Tesla rather than his many other interests and roles at other companies, the board never asked Musk to commit to Tesla any specified minimum percentage of his time).
• Independent directors. Controlled companies, when considering board composition, should carefully weigh the benefits and disadvantages of including independent directors on the board. In the context of conflicted-controller transactions, which generally would include executive compensation for the controller, there are significant advantages to having at least one (and preferably more) directors who are clearly independent of the controller.
  
  
• Crafting an equity compensation plan. Based on the Tornetta situation, a board, when crafting an equity compensation plan, might want to consider imposing a cap on the value of the shares that can be issued. In addition, although potentially cumbersome, a board under certain circumstances might consider having stockholders vote separately on each tranche of the plan, so that, if the plan is challenged, each tranche might be considered separately as to its fairness, which possibly could avoid rescission of the entire plan. Also, if a plan is challenged, to avoid rescission of the entire plan, the company may wish to argue that at least part of the compensation was entirely fair.
  
  
• Ratification. If a board seeks stockholder ratification of a board action, the ratification vote should come before a court issues a post-trial decision invalidating the board action.
  
  
• Disclosure of the effect of stockholder ratification. When disclosing to stockholders the effect of a favorable vote to ratify a board transaction, the company should be careful not to overstate the effect (for example, in an entire fairness context, by stating that ratification will cleanse fiduciary breaches when it may only shift the burden of proof with respect to fairness). Also, a company should consider giving strong prominence to caveats in the disclosure with respect to the possibility that the court might find the stockholder vote invalid or otherwise ineffective.
  
  
• Charge to a special committee. When a company is considering submitting board action on a conflicted-controller transaction to the stockholders for ratification, and there is concern that the action taken could be viewed as not entirely fair, the board should consider tasking the committee with determining whether the action was fair, rather than only the narrow issue whether the action should be submitted to stockholders for ratification.
  
  
• Controller coercion. For a stockholder vote to be effective for MFW (and other) purposes, the vote must have been fully informed and non-coerced. (The court did not need to address the coercion issue in Tornetta II, given its holding that the ratification vote was not fully informed.) A controller should consider carefully any actions that might be construed as coercive with respect to a stockholder vote-such as threatening reincorporation to a different state, or threatening retaliation (e.g., directing resources away from the company) if the vote is not obtained.
  
  
• Controller fiduciary duties. We note that Musk himself may have had fiduciary duties to the other stockholders in connection with his executive compensation, given the court's holding that he was a controller of that process. The plaintiff, however, had asserted claims of fiduciary breach only against the board, not Musk (who, prior to Tornetta II, had never been adjudicated to be a controller of Tesla in general or with respect to any particular board decision).

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