It is a basic precept of Delaware corporate law that a corporation is managed by its board of directors. One of the board’s key managerial functions is the determination of executive compensation levels – a decision typically entitled to great judicial deference. When the board’s decision as to executive incentive compensation is submitted to stockholders for approval, and such stockholder approval is given, the decision is entitled to even greater deference. However, in Tornetta v. Musk, et al., C.A. No. 2018-0408-JRS, decided September 20, 2019, The Court of Chancery highlights an important exception to the general rule when the recipient of the compensation package is also a controlling stockholder.
In January 2018, the Tesla, Inc. board of directors approved an incentive-based compensation plan for the company’s chief executive officer, Elon Musk. Compensation under the plan was predicated upon the attainment of several financial and operational milestones for Tesla. Musk had the potential under the plan to earn stock options worth up to $55.8 billion if the milestones were achieved. Not surprisingly, given the potential size of the compensation award, a stockholder claimed that the board’s approval of the plan was in breach of its fiduciary duties.
This decision was rendered from the board’s early motion to dismiss the stockholder’s complaint. The plan was vetted and approved by (i) a compensation subcommittee of the board and (ii) the majority of stockholders in attendance at a special meeting to consider the plan. The court found that, at the initial pleadings stage, there was sufficient reason to believe that Musk dominated the compensation subcommittee, as well as the board itself. Nevertheless, the board argued that its approval of the plan was ratified by the stockholders, and should be viewed under the deferential business judgment standard. The stockholder challenged that since the plan was for the benefit of the company’s controlling stockholder, Musk, it should be analyzed under the more onerous entire fairness review.
The court recognized that the “earnest deference to board determinations relating to executive compensation does not jibe with [its] reflexive suspicion when a board transacts with a controlling stockholder.” In other words, because Delaware law affords deference to board decisions on executive compensation, but requires exacting scrutiny of transactions with a controlling party, which standard of review should prevail when the board negotiates a compensation package with a controller? The court concluded that it is best to err on the side of caution and subject board decisions on compensation with a controlling stockholder to entire fairness review because the risk of coercion is simply too great.
The court was not unsympathetic to the board’s situation. It posited that boards should be afforded a means to avoid “the costs and downstream implications of fiduciary litigation in the corporate context” when addressing the compensation of a controller. To do so, the court took guidance from In re MFW Shareholders Litigation, 67 A.3d 496 (Del. Ch. 2013), aff’d, Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014). MFW provides a process by which transactions with a controller remain subject to deferential review so long as consummation of the transaction is conditioned from the beginning on the informed and impartial approval of decision makers at both the board and stockholder levels. Historically, the MFW framework has been applied only to transformational transactions, such as a freeze-out merger, sale to a third party, or stock reclassification. The court observed, however, that 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.”
Therefore, the court would have evaluated the approval of Musk’s compensation under the deferential business judgment standard had the board conditioned consummation of the compensation award upon the approval of a fully-functioning, independent committee and a statutorily compliant vote of a majority of the disinterested stockholders. The takeaway is that the court found no principled reason not to extend the MFW framework to a controlling party transaction that does not fundamentally alter the corporate contract. Time will tell, but corporate boards and their advisors should note that this decision likely signals that Delaware law is moving towards the use of the MFW framework to preserve business judgment review for seemingly any transaction between a corporation and a controlling party.