From Mars Back Down to Earth: Lessons from the Rescission of Elon Musk’s $55.8B Option Grant

CEO compensation can be a source of concern for shareholders, which makes it a concern for the Delaware Chancery Court. Another major concern is director independence. The decision by the Delaware Chancery Court to void Elon Musk’s 2018 compensation package demonstrates what happens when these two concerns collide.

The court’s 200-page legal analysis assesses everything from director independence and what constitutes an appropriate board-led process to disclosure for potentially conflicted transactions and the entire fairness standard of review.

In this article, you’ll find out what led the court to rescind Musk’s $55.8 billion Tesla option grants—even though Musk had met aggressive milestones, including growing the company’s market capitalization by more than 10x. I’ll also offer practical tips for directors coming from the case.

How Did We Get Here?

Having the Delaware Chancery Court intervene in corporate compensation decisions is a relatively recent phenomenon. The court fired a shot across the bows of all corporate boards in 2005 with its decision in Disney.

Disney President Michael Ovitz walked away with a $130 million severance payment after just over a year of work. Shareholders reacted by suing the Disney board for breaching their fiduciary duties, including a claim for a breach of the duty of loyalty and for corporate waste.

Although the case was dismissed, the 37-day trial was embarrassing for the Disney board, revealing an approach to corporate governance that was basically characterized by the court as: not great, but good enough for the 1990s.

However, the Disney court was also clear that what was OK in the 1990s (when the compensation package was put together) would not be OK in the future, helpfully providing an outline of the type of activities a court wanted to see. It was also a reminder of how important it is for the board to document its processes.

Of course, Disney wasn’t the last time shareholders challenged large compensation packages. Fast-forward to today, and the Delaware Chancery Court’s decision to strike down the Tesla compensation package.

Tesla Option Grant to Motivate Elon Musk

In 2018, the Tesla board of directors offered Musk, Tesla’s co-founder, CEO, and chairman, the largest compensation package anyone has ever received.

The option grant gave Musk an additional 1% of the company each time the company hit one of 12 increasingly difficult operational and financial goals. The value of this compensation package had a maximum value of $55.8 billion—certainly a lot of money, even though Tesla’s market capitalization currently hovers around $600 billion.

To understand the grant, it is important to understand the context in which the grant was made back in March of 2018. At that time:

• Tesla had a market capitalization just shy of $60 billion.
• Musk was being paid minimum wage, but Musk declined to accept even this amount.
• None of the executives, including Musk, had any cash bonus opportunities.
• Musk had to meet certain aggressive market capitalization and operational metrics to earn the grant.
• Using the methodology approved by the Financial Accounting Standards Board, the value of Musk’s option grant at the time of grant was $2.6 billion, according to the proxy seeking shareholder approval for the option grant.
• To achieve the maximum value of the option, Musk had to grow the market capitalization of the company 10x within 10 years.
• A condition of the grant was shareholder approval.

The grant was approved by 74% of shares not held by either Musk or his brother.

Note that while there is some dispute about the difficulty of the milestones that Musk had to meet,¹ there is no dispute about whether the proxy sent to shareholders in advance of the vote accurately reflected the economic terms of the grant.

So, if a majority of the disinterested directors knew about the economics of the option grant and approved it, why did the court ultimately, after trial, issue a decision rescinding the option grant?

It’s All About Independence

Tesla is a public company—and that is irrelevant to the Delaware Chancery Court’s legal analysis in the Tesla case, which was a derivative fiduciary duty suit.

The shareholder plaintiffs who sued the board of Tesla asserted that the board breached its fiduciary duty and harmed the corporation by granting an overly rich compensation package to Musk. The fact that shareholders approved the grant does not make the suit go away if, as the plaintiff asserts, the proxy statement is defective.

The court concluded that the proxy statement was defective because, although the board characterized its members as independent in the proxy statement, they were not.

The court doesn’t insist that the board members should have stated they were not independent. Instead, the court states that the board members were required to discuss conflicts that might call their independence into question.

What made the board members potentially not independent? As the Delaware Chancery Court has repeatedly held, including famously in cases like Oracle and Blue Bell Creameries, the independence analysis includes social relationships.

It is especially important to consider social relationships when a company’s CEO controls the company, as is the case at Tesla.²

The Chancery Court said that, as a matter of law, it does not matter if the board truly thought that losing the CEO would be more harmful to shareholder value than acceding to his compensation desires. The board still has a job to do, which is to protect the interests of the non-controlling shareholders by running a thorough process led by independent directors.

Here are just some of the elements the court focused on when considering whether the directors were independent:

• Some board members received material amounts of wealth³ from outsized board compensation in the millions of dollars.
• Board members gained material amounts of wealth by investing in other companies controlled by Musk.
• Board members regularly socialized with Musk, including attending weddings and birthday parties (including of children related to the people in question) and vacationing together, particularly as part of a tradition and over Christmas.

Any one of these factors may not have been enough for the court to find a lack of independence. The total picture, however, caused the court to be skeptical that the directors involved in setting Musk’s compensation were independent.

Process, Process, Process

Even if the directors had been independent, however, the court makes it clear that the process followed by the board’s committee demonstrated that the directors handling Musk’s grant operated with a “controlled mindset.” This means they failed to approach the transaction as an adverse party entering a negotiation.

In this regard, the court focused on the cadence of the compensation process, which was very much at the rhythm and timing set by Musk. The court acknowledged that Musk was going to extraordinary lengths to make the production of the Model 3 a success during the period in question.

Even taking into consideration the harsh reality of the operating environment, no one would conclude that the board followed a particularly good process. Indeed, the court provided detailed criticisms of the process board members followed to determine the details of the option grant, including its size and the milestones to meet to earn its full value.

But, given how different Tesla is from any other company, it is surprising that the court focused on the lack of peer benchmarking. The court dismissed this difference as a possible reason to skip peer benchmarking, saying:

As CEO, Musk’s job was the same as every other public company CEO: improve earnings and create value. A benchmarking study would have shown the committee what other companies paid for executives to perform that same task.⁴

Why Pay Him More?

Musk was not being paid in cash, and the equity grant the board had previously granted him—with great success—was soon to expire. Nevertheless, the court criticizes the directors’ failure to conduct real diligence on whether Musk needed further incentives to do his job.

One imagines that the court would not expect Musk to work for free. What the court does is focus on the fact that Musk already owned more than 20% of the company. Increasing the value of the company would translate to increasing his own personal wealth—so why give him more?

In addition, the court took Musk at his word when he said that he would not leave Tesla. The court paradoxically both acknowledges and dismisses Musk’s penchant for taking on multiple big projects at any moment.

During the time in question, Musk was also taking an active interest in The Boring Company, Neuralink, OpenAI, and SpaceX (where he was also the CEO). The court also discussed Musk’s interest in colonizing Mars, noting that Musk makes no bones about working so that he has wealth to fund going to Mars.

The court does not seem to be concerned with the implication that Musk would do something else if he is not generating enough wealth at Tesla.

The court asserted that if board members were really concerned about keeping Musk’s attention on Tesla, the board would have written into Musk’s contract that he spend a specified amount of time on Tesla matters.⁵

Thus, the problems for Musk’s option grant include:

• Musk’s level of control;
• The fact that his compensation package is inherently a conflicted transaction that requires the strong hand of independent directors;
• The board members’ lack of independence; and
• The controlled mindset with which the board approached the option grant, which means there was no real negotiation.

On this last point, there was no credit given by the court for the fact that Musk would sometimes make unilateral decisions that were not to his benefit concerning the stock grant, which is to say negotiate against himself.

The court was also clear that while the company’s general counsel worked to document, process, and otherwise steer the ship appropriately, it was of no help on the independence front. This was in part due to the general counsel’s affection for Musk, a level of affection that moved the general counsel to tears⁶ during his testimony.

Entire Fairness Standard of Review

Unfortunately for Musk and the Tesla board, all of these governance failures meant that the court had to review Musk’s grant using the entire fairness standard, with defendants bearing the burden of proof.

The burden would shift back to the plaintiffs if the defendants were able to show a good process. Unfortunately, the lack of a well-functioning committee of independent directors made this impossible.

The other way to shift the burden back to plaintiffs is if the shareholder vote were fully informed—again, impossible in this instance for the reasons already discussed.

The economic terms of the deal will not suffice to fully inform shareholders if shareholders are also not advised of potential conflicts. There are other failures in the proxy as well in terms of, for example, who was talking to whom about which elements of the grant and when.

Thus, the court was forced to analyze the option grant itself in terms of “fair dealings” and “fair price.”

While the court actually complimented the defense counsel’s efforts, the defense fell short. The court was explicitly unimpressed by the defense’s efforts to assert that it was worth it for shareholders to “give” up equity to “get” the bump in valuation they enjoyed during the timeframe of the stock grant (the “give/get” argument) given that Musk already had a more than 20% equity stake in the company.

Also, the court noted that Musk’s existing equity stake “was also a powerful incentive to avoid allowing Tesla to fall in what Musk might consider to be incapable hands.”

To defend the grant as being a “fair price,” the defense argued that Musk’s equity grant was not abnormal in the world of private equity. It was clear to the court that the private equity argument was one that the defense created for trial, and that this consideration had not been part of the original process to grant Musk’s option grant.

Thus, the court did not need to consider the private equity argument or even whether a public company CEO’s compensation package could be based on private equity benchmarking.

Thus, the court ordered the option grant to be rescinded. No word (as of this writing) on whether the case will be appealed.

Who Pays for All This Litigation?

The Tesla case was a derivative suit against the board of directors, so the proceeds of the shareholder’s win technically go back to the company. This is also what happens anyway when an equity grant is rescinded.

Legal defense costs of directors subject to a derivative claim are indemnifiable by a company, assuming the company is not bankrupt. Thus, if a company is buying classic D&O insurance, one would expect the directors’ defense costs to be paid by the D&O insurance policy, subject to the self-insured retention (similar to a deductible).

These costs will not be paid by D&O insurance if a solvent company is only buying a Side A policy, a policy that only responds to non-indemnifiable claims.

Companies of Tesla's size will often choose to self-insure indemnifiable claims, and some might go so far as to set up a captive to handle non-indemnifiable claims.

In any case, don’t expect insurance carriers to “pay” anyone the value of an executive’s voided compensation agreement given the standard exclusions in D&O insurance policies for that sort of thing.

Even worse, to the extent a board is found to have engaged in wrongdoing, you might see insurance carriers attempt to claw back defense costs from the company.

Practice Tips for Directors

The Tesla decision isn’t exactly a mighty blow in favor of communism. The list of the most highly compensated CEOs included jaw-dropping amounts last year, and next year’s list will be no different.

But boards will want to be mindful of the following practice points if they want to grant unusually large compensation packages to CEOs for legitimate, shareholder wealth-enhancing reasons.

1. Director independence is the whole show. You can be an independent board member, or you can vacation with your CEO, but you can’t do both. You can invest in a lot of different ventures with your CEO, or you can be an independent director, but you can’t do both. Enough said.
2. Avoid the appearance of having a controlled mindset. Boards can respect and esteem their CEOs, but Delaware has made it clear that you can’t adore them to the point of becoming deferential. Also, there’s no crying in baseball.
3. Run the process. The CEO cannot run the compensation process. The board must be in charge of the process, including timing, and ideally the initial economic terms. Also, although the board often functions as a source of advice and counsel for a CEO in the normal course of business, your posture must be one of an arms-length negotiator when it comes to negotiating executive compensation.
4. Document the process. If you, as a director, think your shareholders want you to do something big to motivate your CEO to deliver outsized returns, do this:
   • Read the entire text of the 200-page Tesla decision. 
   • Rest up.

   You will need to be prepared to complete the arduous process and extensive documentation required to survive litigation scrutiny. This advice will be true even if parts of the Chancery Court opinion in Tesla are ultimately overturned. Your goal is not to win on appeal, but rather to avoid litigation in the first place. Failing that, your goal is to win on a motion to dismiss the suit.

The Cost of Sloppy Corporate Governance

Sloppiness when it comes to corporate governance can be costly. In the Tesla case, corporate governance sloppiness cost Musk $55.8 billion.

Reasonable minds can disagree whether a grant this sizable was needed to create the type of enormous value for shareholders that Musk did.

But Tesla’s independence and process failures—some of which are probably a direct result of Musk’s own leadership style—meant that Musk was penalized despite actually delivering value to his shareholders.

¹ This court’s discussion of the milestones demonstrates a lack of understanding of just how extraordinary Musk’s achievements were during the years covered by the option grant. The court is aided in its misunderstanding by certain accounting conventions, which most operators know are just that—conventions. Much like explorers who believed that finding the Americas was not hard after Christopher Columbus ran into them, the court’s analysis infers that meeting the grant milestones was really never in doubt. This is notwithstanding the fact that the court itself notes that for Musk to earn each tranche of his option grant, he would have to grow Tesla’s market capitalization by $50 billion, which was “an amount in market capitalization {roughly} equal to that of the most significant domestic car manufacturers for Musk to earn a single tranche of compensation,” the combined market capitalization of Tesla, Ford, and GM at the time.

² No serious-minded person disputes that Musk controls Tesla. Nevertheless, the court goes to great lengths to lay out in detail the elements of the analysis of why Musk controls Tesla.

³ It is worth reading the opinion for the details on the wealth the Tesla directors accumulated as a result of their relationship with Musk. The amounts are eyebrow-raising, even for the most avowed anti-regulation capitalists among us. The numbers are really, really big for all but one director. The court uses phrases like “life-changing” and “dynastic and generational wealth” to describe it, and accurately so. Also, recall that Chancery Court judges make about $218,000 per year, putting them at the 96th percentile of US individual incomes (Loo, W. US Income Percentile Calculator. Available at: https://www.omnicalculator.com/finance/us-income-percentile. Accessed: Feb 02, 2024.)

⁴ Regardless of whether one is a fan of Musk or not, it does not track reality to take the position that Musk’s job was the same as any other CEO. As such, it’s hard to see how peer benchmarking would have been helpful, given the uniqueness of Musk and Tesla.

⁵ This is a tough one. On the other hand, it beggars belief that the court thinks a creative serial entrepreneur like Musk would work at a place that required him to “clock in.” On the other hand, one is sympathetic to shareholders seeing Tesla underperform while Musk is clearly spending time on a variety of distracting projects. See more recently, e.g., reports about Musk and Twitter.

⁶ References to the general counsel’s tears appear in the opinion on three separate occasions. This opinion is not the first time the Chancery Court characterized tears as being evidence of a lack of independence. See, e.g., Tears of a Director, discussing a case concerning weeping as a sign of a director’s lack of independence.