The fairness, the entire fairness, and nothing but?

So, we know that the pay award to Elon Musk by Tesla’s board, to a value that turned out to be over $50 billion, was not entirely fair. The Delaware court has told us this, applying the wonderfully named ‘entire fairness doctrine’. But in proposing that shareholders again approve the award, the Tesla board says that its reinstatement is a necessary step to be fair to Musk.

This is set up as a battle of fairnesses. Is it? I’ll try to break the answer to that question down.

Proxy Statement arguments

When reading the Tesla Proxy Statement, it appears that the board doesn’t believe it has a case to answer, even though it has lost one. Robyn Denholm, in her chair’s letter that opens the Proxy Statement, says that restoring Musk’s pay award “is a matter of fundamental fairness and respect to our CEO”. Further, the voiding of the scheme was “fundamentally unfair, and inconsistent with the will of the stockholders who voted for it”.

None of the damning Delaware court findings (essentially that there was no negotiation process with Musk on the pay scheme, those board members charged with the process of developing the pay plan were not fully independent of him, that some of the performance metrics were not in fact stretching, and that shareholders were misled in the company’s communications, so that their approval of the deal was void) are in any way addressed by the Tesla board in their formal communication. The Proxy Statement explicitly confirms that there has been no attempt at a renegotiation of the pay scheme with Musk. The sole nod to the court’s findings is the creation of the new so-called ‘independent Special Committee’.

This new ‘independent Special Committee’ is not worthy of at least one of those words given that the ‘committee’ was personned by just a single director, Kathleen Wilson-Thompson. Director Joe Gebbia withdrew from the committee when its remit was expanded from the question of whether Tesla should redomicile to Texas (discussed further below) to also include Musk’s pay. “Mr Gebbia explained that he was stepping down from the Special Committee out of an abundance of caution because of the potential for unfair attacks based on perceived conflicts of interest. He stepped down entirely of his own accord,” the Proxy Statement reads.

The Proxy Statement does note that the Delaware court found failures in its processes and invites shareholders to read relevant parts of the Tornetta decision (and publishes that decision in full as an appendix). But it does not directly respond to those findings, which are damning about the board’s behaviour and processes. In failing to deliver ‘entire fairness’, the court found that the board failed to deliver both a fair process and a fair outcome. The Proxy Statement doesn’t seek to demonstrate the fairness of either, only that the proposed remuneration scheme was unusual and unusually stretching in the US (such as including features which are unusual in the US but pretty normal in non-US markets such as a five-year time horizon and extended shareholding periods). The court strongly doubted the need for such a scale of award in order to retain Musk’s services for Tesla – which had seemed a strongly motivating factor in the board’s decision-making. After all, Musk owns more than 20% of the company and this shareholding represents well over half of his net worth.

On that issue of Musk’s major shareholding, the Proxy Statement’s main argument that the pay scheme needs to be resurrected is that Musk has received no reward for the extraordinary market capitalisation increase of Tesla over the period since 2018. This absence of any recompense is the source of its argument that fairness requires the scheme to be revived. It does ignore the fact that as 20% shareholder, Musk’s overall wealth increased by more than $100 billion as the value of the business grew from around $55 billion to $650 billion (even for a brief while over $1 trillion) over the life of the scheme. For the board, this share value appreciation is apparently not sufficient to satisfy fairness – though the court explicitly noted it as a reason why setting aside the pay scheme was an equitable remedy.

The Proxy Statement summarises the Tornetta findings but does not directly respond to them. In effect, while the board says it intends to appeal the findings, the proposal to the shareholders is simply to confirm the pay scheme without addressing any of the fairness questions raised by the court. So in order to unpick things more fully we need to consider the Delaware court’s judgement and the evidence that it considered.

The entire fairness doctrine is brought to bear because Musk was found to be a controller of Tesla, and the pay scheme amounted to a conflicted-controller transaction. Such transactions can only be pursued if that is done in an entirely fair way – both the process and the outcome need to be fair. Let’s look at each.

Was the process fair?

While it summarises much of the Tornetta decision, the Proxy Statement provides none of the detail of the questions raised about the independence of the individuals charged with leading the ‘negotiations’ on the scheme.

It’s important to note that while the Delaware court reflects evidence about the question of directors’ independence, it reached no absolute conclusion on this point directly because it found that the entire fairness doctrine applied because of its finding that Musk is a controller of Tesla. It did, however, make findings about whether the directors were beholden to Musk. Investors are likely to draw conclusions regarding independence from the court’s finding that directors were either “beholden” to Musk or “acted beholden” to him with regard to the pay scheme.

The court sums up its finding about the effective independence of the board in the pay scheme process: “Put simply, neither the Compensation Committee nor the Board acted in the best interests of the Company when negotiating Musk’s compensation plan. In fact, there is barely any evidence of negotiations at all.” The form and shape of the pay scheme were largely what Musk had suggested to the chair of the compensation committee at the start of the process, with only minor amendments over the time between that and its approval.

These directors’ main go-between to Musk, who also drafted most of the documents the company leant on to argue that its decision-making was fair, was Tesla’s general counsel. This individual, Todd Maron, was Musk’s former divorce lawyer who held back tears both during his deposition and at trial, in discussing the pain of his 2019 departure from Tesla, and the depth of his positive feelings about the company and its executives.

The Delaware court makes clear that the process of developing the pay plan, including a precipitant timetable, and then a slightly slower but still aggressive timetable, were driven by Musk, not by the committee. The court raises significant doubts as to the independence of the process by which the proposals were tested on institutional investors as they were progressed (for example, it states: “the script reads like a loaded questionnaire intended to solicit positive stockholder feedback and not a method for gaining objective stockholder perspectives on a potential new plan”).

The court also found key gaps in the proxy statement disclosures on which shareholders based their decision to approve the 2018 plan. These included failures to disclose questions about independence of directors from Musk, the nature of the discussions of the plan (particularly their origin as a proposal from Musk himself), and the ease with which Tesla believed it could achieve the operational targets (they were instead stated to be “very difficult to achieve”). Investors were not fully and fairly informed by the 2018 proxy statement, so their approval of the pay scheme isn’t sufficient to overturn the findings of unfairness.

The process was not fair, in multiple ways.

Was the outcome fair – essentially, was the quantum fair?

Musk set the scale of the pay scheme award, initially calling for 15% of the company in 1% increments and then later seeking 10% on a fully diluted basis. The board chose 12% because it preferred to calculate based on issued shares rather than the more complicated diluted basis. No one throughout the process seemed to question this order of magnitude of award. Again, this was not a fair and independent process, but is the outcome, the quantum, fair?

Looking at the current circumstances provides helpful context on this. Musk seems again to be directing matters, including directing the scale of any future awards. In the Proxy Statement, Tesla states that Musk has indicated he would expect any replacement incentive, should the current proposals fail, to be of a “similar magnitude to the 2018 CEO Performance Award”. Oddly, it is clear from the rest of the discussion of the potential costs of such a possible award, that this doesn’t mean a similar order of value in dollars, but an award of the same number of shares: 303 million (at least, this is the equivalent number of shares following repeated share splits). This would have a value at award date of around $25 billion rather than the value at award date of the 2018 award of a still extraordinary $2.3 billion (according to the Proxy Statement, $2.6 billion according to the Delaware court).

As a brief aside on that slight discrepancy in the reported fair value at grant of the awards ($2.3 billion or $2.6 billion – though what’s $300 million between friends?), one of the key interventions by compensation committee chair Ira Ehrenpreis, who was leading the board’s supposedly independent working group on the pay scheme, seems telling. The court reports “a request from Ehrenpreis for “creative options” they could employ to “solve for getting a bigger discount” on the publicly reported grant date fair value”. This appears to be one of the drivers for the unusual (at least in the US context) five year holding period for the shares. The sense that the numbers presented to shareholders were subject to manipulation to put the proposals in the best light, rather than presented fairly and straightforwardly, seems strong.

The Delaware court states (my emphasis added): “With a $55.8 billion maximum value and $2.6 billion grant date fair value, the plan is the largest potential compensation opportunity ever observed in public markets by multiple orders of magnitude—250 times larger than the contemporaneous median peer compensation plan and over 33 times larger than the plan’s closest comparison, which was Musk’s prior compensation plan.” The mooted replacement award would be 10 times larger than this, i.e. more than 2000 times the now-increased median.

Oddly though, the Delaware decision reports that at trial, Musk stated “unequivocally that he would have remained at Tesla even if stockholders had rejected a new compensation plan”, because of his heavy investment in the company “both financially and emotionally”. And the Delaware court reports that there is no evidence that the compensation committee even considered the question of whether additional pay for Musk was needed, given his existing share ownership in the company; this question was put to them belatedly in the process by their compensation consultant, but apparently not discussed. “The most curious thing about this question is that there is no evidence that any director deliberated over it, and it did not appear in any other Board or committee materials,” the court states.

Even though the board’s stated intent was to keep Musk as a fully engaged CEO, the terms of the pay scheme in fact permitted him to stand down to the role of chief product officer.

So this extraordinary quantum of award was not necessary to retain and motivate its recipient, and it was not in practice designed to do so. There was no negotiation over quantum, nor even any real discussion of it. In these absences, the quantum cannot be said to be fair.

Broader applications of fairness

Investors shouldn’t place too many expectations on this case for setting broader precedents on the willingness of the US courts to intervene on matters of executive pay. The judge states that “A board of director’s decision on how much to pay a company’s chief executive officer is the quintessential business determination subject to great judicial deference.” The entire fairness doctrine was triggered in this case by Musk’s dominance of the board’s decision-making. Even in a market where corporate culture facilitates unusual dominance by corporate leaders, Musk’s position at Tesla is unusual.

Instead, at most US companies, the burden of determining what is and isn’t fair will remain with the board, and with investors. The Delaware decision may lead to a little more circumspection among US corporate boards, but it won’t lead to a transformation.

Instead, we will need to continue to rely on investors to try to hold the line on what level of executive pay is fair. As I’ve discussed previously, many don’t have a great record on that. And it’s notable that the Tesla case itself was not sparked by any institutional investor; rather it was brought in the name of an individual, Richard Tornetta. Institutions should be grateful to Tornetta, to the collective tune of over $50 billion, for raising questions about the pay deal. The case was legally a derivative action, so that while it was brought in the name of a single shareholder it was actually carried forward in the name of the company itself, on behalf of all shareholders, and the value of the decision accrues wholly to Tesla.

What might the investor approach be to the forthcoming AGM?

Investors will be faced with a number of key resolutions at the AGM, now set for June 13.

Investors will have to decide whether they can support the re-elections of the board. This may be particularly challenging given the court’s finding that directors are either “beholden” or “acted beholden” to Musk in relation to the pay scheme. The two directors up for election (Tesla being one of the unusual companies in the US with a so-called classified board, meaning not all directors stand for election each year) are James Murdoch, whom the court found to be “beholden” to Musk given their close personal relationship, and Kimbal Musk, Elon’s brother.

The second key decision at the AGM is the plan to shift the domicile of Tesla from Delaware to Texas. The so-called ‘independent Special Committee’ also worked on this resolution. We are told this proposal is not as a fit of pique because of the Delaware court decision, though Musk polled his X (ex-Twitter) followers on the domicile question almost immediately after that court decision. The board takes up 40 pages of the Proxy Statement to explain the detail of its entirely independent thought processes which have ended up in making the same proposal to shareholders as Musk had asserted the company would following the 87% support of his poll of followers.

Given how effective the Delaware court has just proven to be in protecting shareholder interests, it would be surprising if institutional investors welcomed a move to the unproven corporate law jurisdiction in Texas (as the Proxy states, “Texas’s business courts were just created and will not start hearing cases until September 2024”). Further, those shareholders who care about the existence of multiple share classes and the differential voting rights often associated with them may be interested to note that the draft articles of the intended Texas reincorporation include the creation of a separate class of preference shares, with the board having explicit powers to determine all characteristics of these shares as and when issued, including voting rights (Tesla currently only has one share class). Investors will need to consider if they trust this board to exercise that broad discretion fairly and well.

There are a number of shareholder resolutions, perhaps most notably one considering the Tesla policy on freedom of association and collective bargaining, and one regarding anti-harassment and discrimination efforts.

But inevitably, the main focus of attention will be on resolution 4, which seeks to reinstate the Musk pay scheme. While the Proxy Statement sets this up as a battle of fairnesses, in perhaps a first for this blog, I suggest that shareholders – at least institutional investors – do not in fact need to think about fairness when considering this proposal. They just need to think about their fiduciary duties.

It seems to me impossible to understand how any investor motivated by fiduciary duties can vote in favour of the proposed resurrection of the pay scheme. Whether it was right in the first place – and the court’s holding that it was not entirely fair is robust, and oddly unchallenged in its details by the Tesla board – the proposal now is to make an award to an individual for value that has already been created (and some of which has since dissipated given more recent share price falls). The proposal will create no new value for shareholders, rather it is simply to give money away for no benefit. That is not a fiduciary-led decision. While it is still called a 100%-performance linked award, there is no performance still to be delivered.

The clients to whom those fiduciary duties are owed may well seek particularly robust justifications from any fund manager that decides to vote in favour of making a gift – especially such a sizeable gift.

One further unfairness?

As a final brief comment, at some time this summer (most likely), the Delaware courts will assess the fees due to Bernstein Litowitz Berger & Grossmann LLP for their work on the Tornetta case. The law firm has claimed around $5.5 billion for protecting shareholders from the cost of more than $50 billion through the pay scheme; that is calculated by looking at percentages of awards previously allowed as costs for lawyers, but is clearly an extraordinary sum (it amounts to some $275,000 for each of the near 20,000 hours apparently worked on the case). Whether the courts – and shareholders – regard this as fair, let alone entirely fair, remains to be seen. The Proxy Statement notes one benefit of the reinstatement of the pay scheme as being that this legal cost would not be faced; whether that’s true, and whether it is sufficient justification for the board’s proposal, seems highly debatable.

See also: The madness, let alone unfairness, of US executive pay

The Gini in the executive pay bottle

The unfairness of dual class shares

I remain happy to confirm that the Sense of Fairness blog is an entirely personal endeavour.

Tornetta v Musk, C.A. No. 2018-0408-KSJM, 2024 WL 343699, Delaware Chancery Court, January 30 2024

Tesla proxy statement (DEF 14A), Securities and Exchange Commission, April 17 2024

Bernstein Litowitz Berger & Grossmann LLP on Tornetta v Musk

Tornetta v Musk is the Rule of Law at Work, Holger Spamann, Harvard Law School Forum on Corporate Governance, February 27 2024

The Bill comes Due, Ann Lipton, Oxford Business Law Blog, February 2 2024