In 2018, Tesla's leadership took a daring leap, promising Elon Musk a reward package that could climb to an astounding $55.8 billion if he met certain lofty milestones. This decision set the stage for one of the most talked-about executive compensation cases in recent history.
Unfortunately for Musk, this groundbreaking package also came under legal scrutiny, leading to a significant court ruling that would ultimately rescind Musk's compensation package.
In this article, I'll briefly discuss the case, and more importantly, what officers and directors can do to avoid a similar situation.
Musk's Unprecedented Compensation Package
In 2018, Tesla's valuation approached $60 billion. Nevertheless, Musk opted not to receive any cash compensation.
Also, Musk was just coming off the heels of his last performance-based option grant, which by all accounts was a success. In just five years, Musk had grown Tesla’s market capitalization by more than 15x from $3.2 billion to $53 billion.
Given the success of the previous grant option, the board began discussing what the next one would look like for Musk.
At the time of the decision, the value of the option grant was $2.6 billion and included an additional 1% stake in the company each time Tesla achieved one of 12 increasingly difficult operational and financial milestones.
To unlock the full potential of this option grant, Musk was tasked with increasing Tesla’s market value tenfold over a decade.
This plan, if brought to fruition, would garner a $55.8 billion reward for Musk, setting a record as the most generous remuneration package offered to a business leader.
Legal Challenges Against Musk’s Compensation
Stockholder plaintiffs sued Tesla's board in Tornetta v. Musk for breaching their fiduciary duty, claiming directors damaged the company by awarding Musk an excessively generous compensation package. The suit was brought even though the compensation package had been approved by a stockholder vote.
Director Independence
Unfortunately for Musk, the Delaware Chancery Court took the position that shareholder endorsement doesn’t mean a thing if the proxy statement is defective.
The court said the proxy statement was defective because it misrepresented Tesla’s board members as independent when they were not.
The court took issue with the directors' social and financial relationships with Musk. The legal analysis looked at the following:
● Directors maintained close personal relationships with Musk, marked by attending one another’s weddings and birthday celebrations (children’s birthdays) and holidays together, such as Christmas vacations.
● Several board members received millions in Tesla board compensation, compensation the court described as “life-changing” and “dynastic and generational wealth." Some also increased their fortunes by investing in companies under Musk's control.
Additionally, the court described Musk as a "Superstar CEO", underscoring the need for an independent board.
Governance Failures
The court further analyzed the Tesla board’s governance around the compensation package and criticized many areas of the board's process, including a lack of peer benchmarking.
Throughout the process, Musk had been heavily involved in setting the terms of the package and the pace of the process. At the end of the day, the major issues with the option grant included that:
● It was a conflicted-controller transaction due to Musk's level of control.
● Board members lacked independence and had a "controlled mindset" such that there was no real negotiation between Musk and his board.
Because the board was not independent, the court applied the most stringent standard of review under Delaware Law to Musk's compensation package, the entire fairness standard of review.
In January 2024, in a 200-page post-trial opinion, the Delaware Chancery Court ruled against the Tesla board for the reasons listed in this article and more and rescinded Musk's compensation package. (Tesla may appeal the decision.)
Takeaways
Lack of director independence and process issues for his compensation package ultimately cost Musk billions of dollars, even though he delivered enormous value to shareholders.
Can a board ever award a $55.8 billion pay package to a CEO? Yes—but only if the board is independent and can follow what is really a bare minimum of process.
Here are some key takeaways boards can apply to their process when determining CEO compensation:
Make Sure the Board Is Actually Independent
Over the years, Delaware has evolved its view of what “conflict of interest” means in business dealings to go beyond the business itself and look at how intertwined relationships are beyond the boardroom, as we have learned with cases like Oracle, Sandys v. Pincus and Marchand v. Barnhill et al. (the Blue Bell Creameries case). Social relationships are something the Delaware court takes seriously when assessing director independence.
In Tesla’s case, the board of directors had deeply intertwined relationships with the CEO as they invested in ventures together and spent time outside the boardroom, including vacationing together, celebrating holidays with one another, and attending family weddings and birthdays.
We all understand that a well-functioning board is typically characterized by a constructive and congenial atmosphere. However, it is incumbent upon directors to continue to understand the difference between being congenial versus beholden to their CEO.
Run the Process Well
The CEO cannot be the one running the CEO compensation process.
If it’s an independent board (or compensation committee) negotiating a CEO’s pay package, courts will generally defer to the board’s judgment absent indications that the board members have a "controlled mindset."
Otherwise, the court will review the pay package to see if it is fair to the stockholders. That is when having engaged in things like peer benchmarking and other financial analysis will be important.
What if you have an atypical CEO, as is surely the case with someone like Musk?
In such cases, it’s probably best to have benchmarking and note why it makes sense to depart from it rather than to have no benchmarking at all. The court is eager to defer to independent boards when the record reflects a thoughtful and deliberate process.
