Fiduciary Duties, Business Judgement Rule, Entire Fairness Standard of Review and Execpay

We will review in this post a thorough analysis by Anna Restuccia, (Hardvard Law School), on the Delaware court decision on 2018 Tesla´s compensation plan for Elon Musk. (1)

Elon Musk pay scheme as it was setup in 2018 has faced a setback as Delaware Courts have ruled board members did not act well. He was offered 12 stock option tranches (for 1% of outstanding shares each) each tranche to vest under certain cumulative conditions (50 billion in market capitalization increase each, plus some sustainable adjusted Ebitda or Revenue targets). Grant date fair value was establised at 2,6 billion, and maximum package was up to 55,8 billion. Pay opportunity was some 33 times bigger than his last pay package and some 250 times its peers higher schemes.

The plaintiff argued that this decision was taken in a conflicted controller-stockholder situation; Elon Musk held 21,9% of Tesla shares, he was the founder, powerful CEO and Chair; he also had strong ties to some directors deciding on the matter and dominated the decision-making process that led to the pay package. This implied that Courts should use an entire fairness standard, so that the defendant should prove that the plan was fair. Only if the decision had been taken by a majority of the minority shareholders on an informed way could the defendant have avoided this standard, and the plaintiff argued the decision was not informed.

Expropriating control: the case of Rights Offers

Leeor Ofer has just published a post in the Harvard #Corpgov blog, (1) where she summarizes her forthcoming article on “Control Expropriation via Rights offers”, (2).

A rights offer is a way to raise capital, on a current shareholding pro-rata basis, normally offering a discount on the trading price. Shareholders can then use the right and buy the shares, thus keeping their pro-rata on the company´s equity, (or sell their rights and get the discount value, if this possibility exists, and the market for the rights is efficient).

Rights offers are advantageous: (i) they may not require a shareholder approval if a previous general approval is in place; (ii) undervalued issuers may use it and avoid granting value to third parties; (iii) transaction costs are reduced; and (iv) as rights offers grant all shareholders the same options, the business judgement rule (BJR) is easily applied to these board decisions aiming at organizing a rights offer.

There is a possibility that dominant shareholders or insiders use the rights offer in order to acquire cheap stock, so as to improve the value to be captured by their investment, as small shareholders might not have enough funds, or could face uncertainty over whether the share is over or underpriced, thus using only a part of their rights to actually acquire shares, (cheap-stock tunnelling, as Fried and Spamann have recently argued (3)).

Rights offers designed to achieve control this way or the way explained below, avoiding takeover requirements and stricter fiduciary duties´control, can harm corporate governance standards.

Leeor Ofer explains that a third expropriation method may be used by dominant but non-controlling shareholders. If the offer is overpriced, (completely outside the uncertainty price area), even absent all other impediments, outsiders would avoid participating in it. This is why insiders would be able to increase their control, and afterwards extract private benefits (making the price attractive), to the detriment of minority shareholders.

Entire Fairness Review of SPAC transactions

Lest´s explain the case particulars first (1): shareholders of Spac Churchill Capital Corp III presented a complaint against its directors, in the belief that the proxy statement prepared for them on the occasion of the Spac merger with Multiplan Inc. did not include material facts that finally affected the stock price of the combined company by a third. The material fact missed in the proxy was the possibility that a customer to 35% of its sales was thinking to stop its purchases and instead become a competitor to Multiplan in its market.

The Delaware court that analyzed the case first decided compensation if any would go direct to the stockholders, not to the company, their right to decide informed having been damaged directly; and accepted the case as a fiduciary duty´s case.

The court decided that the Business Judgement Rule should not be granted to directors, and based this decision on two main building blocks: