Stephen M. Bainbridge is William D. Warren Distinguished Professor of Law, UCLA School of Law and serves as the WLF Legal Pulse’s Featured Expert Contributor, Corporate Governance/Securities Law.
In an important recent decision, Tornetta v. Musk,1 the Delaware Chancery Court provided new guidance on how to structure conflict-of-interest transactions to which a corporation’s controlling shareholder is a party. The case involves a shareholder lawsuit challenging an incentive compensation plan granted to Tesla, Inc.’s CEO, Elon Musk. The plan laid out twelve tranches of stock options to be awarded over a ten-year period. In order for Musk to receive each tranche, Tesla had to achieve specified milestones in market capitalization and operating results. According to the Plaintiff, the fair present value of the award was either $2.6 or $3.7 billion, which allegedly dwarfed CEO compensation at Tesla’s peer companies by orders of magnitude.
Tesla’s board of directors and its disinterested shareholders approved the compensation plan. Seventy-three percent of the disinterested shares were represented in person or by proxy at the stockholder meeting during which the plan was approved voted. They represented 47% of the total number of outstanding disinterested shares.
In his opinion, Vice Chancellor Joseph Slights acknowledged that Delaware courts normally approach boards’ executive compensation decisions with a high degree of deference. Critically, however, Musk is not just Tesla’s CEO but also its controlling shareholder.2 A controlling shareholder has been analogized to the proverbial 800-pound gorilla,3 which gives rise to “an obvious fear that even putatively independent directors may owe or feel a more-than-wholesome allegiance to the interests of the controller, rather than to the corporation and its public stockholders.”4
In response to that risk, Delaware law imposes a more intrusive standard of review on conflicted-controller transactions than on ordinary business decisions. In the latter, the standard of review is the business judgment rule; in the former, however, the burden of proof shifts to the conflicted controller to show that the transaction was fair to the corporation and its minority shareholders. In Kahn v. Lynch Communications Systems, Inc.,5 for example, the Delaware Supreme Court reaffirmed that the “exclusive standard of judicial review in examining the propriety of an interested cash-out merger transaction by a controlling or dominating shareholder is entire fairness.” Having said that, however, the Kahn court further held that “approval of the transaction by an independent committee of directors or an informed majority of minority shareholders shifts the burden of proof on the issue of fairness from the controlling or dominating shareholder to the challenging shareholder-plaintiff.”
The Kahn court’s description of fairness as the “exclusive” standard of review seemed to preclude invoking the business judgment rule in conflicted-controller transactions. In its 2014 decision in Kahn v. M & F Worldwide Corp. (“MFW”),6 however, the Delaware Supreme Court held that “when a controlling stockholder merger has, from the time of the controller’s first overture, been subject to (i) negotiation and approval by a special committee of independent directors fully empowered to say no, and (ii) approval by an uncoerced, fully informed vote of a majority of the minority investors” the standard of review becomes the business judgment rule.7
In Tornetta, the Tesla defendants argued that MFW was irrelevant to the facts of this case:
They rely heavily on a ‘statutory rubric’ argument, claiming MFW’s dual protections, devised in the context of a squeeze-out merger, mimic the approvals required by 8 Del C. § 251 but have no practical application to transactions where our law does not mandate approval at both the board and stockholder levels. … I do agree with Defendants that nothing in MFW or its progeny would suggest the Supreme Court intended to extend the holding to other transactions involving controlling stockholders.8
Vice Chancellor Slights, however, observed that the risk of coercion is just as present when a conflicted controller enters into a compensation arrangement as when it proposes a freezeout merger:
Indeed, in the CEO compensation context, the minority knows full well the CEO is staying with the company whether vel non his compensation plan is approved. As our Supreme Court observed in Tremont II:
‘[I]n a transaction such as the one considered … the controlling shareholder will continue to dominate the company regardless of the outcome of the transaction. The risk is thus created that those who pass upon the propriety of the transaction might perceive that disapproval may result in retaliation by the controlling shareholder.’
These words apply with equal force to the compensation setting.9
Accordingly, in order for a conflicted-controller transaction to be reviewed under the business judgment rule rather than entire fairness, the transaction must receive both of MFW’s dual protections.
On the facts before it, the Vice Chancellor—for purposes of defendants’ motion to dismiss—concluded that:
I have determined on the pleadings that Defendants have satisfied the ‘majority of the minority’ condition but have not satisfied the ‘fully functioning, independent special committee’ condition. The burden of persuasion shifts to Plaintiff, therefore, to demonstrate the Award is not entirely fair. At this stage, the bar set for Plaintiff is to demonstrate from well-pled facts that it is reasonably conceivable the Award is unfair to Tesla. [H]e has cleared the bar, albeit just barely.10
The Vice Chancellor’s conclusion that the “majority of the minority” vote requirement was satisfied required him to distinguish then Chancellor (and now Chief Justice) Leo Strine’s decision in In re PNB Holding Co. Shareholders Litigation11 In that case, plaintiff shareholders had challenged a freezeout merger with a controlling shareholder. In that context, Strine held that approval of a conflicted interest transaction by a “majority of the minority” means approval by a majority of the outstanding disinterested shares not just a majority of those present and voting:
The cleansing effect of ratification depends on the intuition that when most of the affected minority affirmatively approves the transaction, their self-interested decision to approve is sufficient proof of fairness to obviate a judicial examination of that question. I do not believe that the same confidence flows when the transaction simply garners more votes in favor than votes against, or abstentions from, the merger from the minority who actually vote. That position requires an untenable assumption that those who did not return a proxy were members of a ‘silent affirmative majority of the minority.’ That is especially so in the merger context when a refusal to return a proxy (if informedly made) is more likely a passive dissent. Why? Because under 8 Del. C. § 251, a vote of a ‘majority of the outstanding stock of the corporation entitled to vote’ is required for merger approval, and a failure to cast a ballot is a de facto no vote. Therefore, giving ratification effect only if a majority of the disinterested shares outstanding were cast in favor of the transaction also coheres with § 251. [FN74]
FN74. I need not, and do not, hold that a qualifying ratification vote always needs to track the percentage approval required for the underlying transaction. One can posit a situation when a particular type of transaction requires, by charter, a 66.67% supermajority vote, and a conflicted stockholder holds 40% of the total vote, with the rest of the votes held by disinterested stockholders. To promote fair treatment, the board makes approval subject to a majority of the minority vote condition. Nothing in this opinion suggests that ratification effect would not be given if an informed majority of the minority of the remaining 60% of the electorate voted in favor of the transaction.12
As Vice Chancellor Slights observed, however, DGCL § 251 required that the freezeout merger at issue in PNB—like all mergers—be approved by a majority of the outstanding shares. In contrast, under DGCL § 216(2) ordinary matters only require the affirmative vote of a majority of the shareholders present at the meeting. Accordingly, the court limited PNB’s definition of the majority of the minority to cases in which the statute requires approval by a majority of the outstanding shares.
This aspect of the Vice Chancellor’s decision is less well supported than the remainder of his analysis. First, neither § 216 nor § 251 expressly applies to conflicted-controller transactions. Those statutes speak to the basic vote required to authorize corporate action, not to the vote required to insulate a conflict-of-interest transaction from judicial review for fairness. Second, a close reading of Strine’s decision shows that he saw § 251 as strengthening the underlying argument for requiring approval by a majority of the disinterested shares rather than just a majority of the disinterested shares present at the meeting.
Overall, however, Vice Chancellor Slight’s opinion is a well-reasoned and persuasive extension of the trend in Delaware law towards judicial deference to corporate actions that benefited from procedural safeguards designed to ensure that the pertinent decision makers are free from coercion by a conflicted controller. It strengthens the argument that MFW is not limited to freezeout mergers, but rather now provides a roadmap by which all conflicted-controller transactions can receive the protections of the business judgment rule.
- 2019 WL 4566943 (Del. Ch. Sept. 20, 2019).
- In an earlier decision involving Tesla, Vice Chancellor Slights had determined that Musk was Tesla’s controlling shareholder despite owning only 22% of Tesla’s voting stock. See In re Tesla Motors, Inc. Stockholder Litig., 2018 WL 1560293 (Del. Ch. Mar. 28, 2018), appeal refused sub nom. Musk v. Arkansas Teacher Ret. System, 184 A.3d 1292 (Del. 2018).
- In re Pure Resources, Inc. Shareholders Litig., 808 A.2d 421, 436 (Del. Ch. 2002).
- Leo E. Strine, Jr., The Delaware Way: How We Do Corporate Law and Some of the New Challenges We (and Europe) Face, 30 Del. J. Corp. L. 673, 678 (2005).
- 638 A.2d 1110, 1117 (Del. 1994).
- 88 A.3d 635 (Del. 2014).
- As the Supreme Court summarized its holding:
[T]he business judgment standard of review will be applied if and only if: (i) the controller conditions the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders; (ii) the Special Committee is independent; (iii) the Special Committee is empowered to freely select its own advisors and to say no definitively; (iv) the Special Committee meets its duty of care in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority.
Id. at 645.
- Tornetta, 2019 WL 4566943 at *13. The defendants’ argument is supported by some commentators, as Ann Lipton has pointed out:
Itai Fiegenbaum argued that entire fairness should be the rule – even with MFW procedures in place – for less than transformative transactions. See Fiegenbaum, The Controlling Shareholder Enforcement Gap, Am. Bus. L.J. (forthcoming). Fiegenbaum claims that in a squeeze out kind of transaction, all eyes are on the controller, there’s a real likelihood of litigation, and that scrutiny coupled with MFW procedures may protect minority stockholders. But in more ordinary transactions, that frequently will need to be brought derivatively and thus satisfy the demand requirement, controllers know that the chance of litigation is slight.
Vice Chancellor Slights did not address that concern.
- Id. at *11-12.
- Id. at *14.
- 2006 WL 2403999 (Del. Ch. 2006).
- Id. at *15.