In Tornetta v. Musk, Civil Action No. 2018-0408-JRS (Del. Ch. Sep. 30, 2019), the Delaware Court of Chancery addressed the appropriate standard of review to apply when examining stockholder approval of a conflicted controller for the controller’s own executive incentive compensation package. In January 2018, Tesla, Inc.’s board of directors (the “Board”) approved a compensation package (the “Award”) for its CEO, Elon Musk. The Board then submitted the Award to Tesla’s stockholders for approval. The Award was overwhelmingly approved. Tornetta (“Plaintiff”), a Tesla stockholder, brought four direct and derivative claims against Musk and members of the Board (the “Defendants”) alleging the Award is a product of breaches of fiduciary duty, constitutes waste, and unjustly enriches Musk. The Defendants moved to dismiss all counts under Rule 12(b)(6) (the “Motion”).

Ordinarily, a decision by the Board to approve executive compensation receives substantial judicial deference—even more so when the stockholders approve that compensation package—and the court would apply the business judgment rule. However, the court here found that this case is atypical because (1) the beneficiary is the controlling stockholder; and (2) the size of the Award is extraordinary, valued at $55.8 billion. While the Award is large, the court—perhaps foreshadowing a future decision on the merits—noted that it is heavily tied to incentives that, if met, would make Tesla one of the most valuable companies in the world. By differentiating the Award from an ordinary executive compensation package, relying mainly on the fact that this is a conflicted controller transaction, the court addressed this as an issue of first impression for Delaware. Defendants argued that the stockholder vote approving the Award ratified the Board’s decision to adopt it and thereby entitles it to business judgment review. In response, Plaintiff advanced the theory that stockholder ratification cannot alter the standard of review with respect to a conflicted controller transaction.

An earnest deference to board determinations relating to executive compensation does not sit in harmony with Delaware’s reflexive suspicion of board transactions with controlling stockholders. The court compared the facts in Tornetta to controlling precedent, In re MFW S’holders Litig. “Preserving the integrity of the decisions at both [board and stockholder] levels in the conflicted controller context is key to allaying the court’s suspicions such that the court’s preference for presumptive deference can be restored.” While the holdings in MFW were not expressly intended to apply outside of the merger context, the Chancery Court has subsequently applied the MFW framework to controller transactions involving the sale of a company to a third party and a stock reclassification. Defendants argued that these are all transformative transactions that “fundamentally altered the corporate contract,” and that the MFW cleansing procedures required to earn business judgment deference should be limited to such transformational controller transactions.

The court disagreed, stating that “a controlling stockholder’s potentially coercive influence is no less present, and no less consequential, in instances where the board is negotiating the controlling stockholder’s compensation than it is when the board is negotiating with the controller to effect a ‘transformational’ transaction.” As such, stockholder ratification in this context does not balance the risk of coercion. In addition to determining that entire fairness is the correct standard of review to apply in the context of a conflicted controlling stockholder ratifying an executive compensation package for which the controller is the beneficiary, the court adopted Plaintiff’s argument that MFW provides the procedure by which business judgment review may guaranteed.

The court granted the Motion as to allegations of waste because of a majority of the disinterested stockholders approved the Award, even if the voting procedure was not statutorily compliant to receive MFW cleansing. As to the other claims, the court denied the Motion for unjust enrichment and breaches of fiduciary duty. Though the claims are duplicative—a recovery would only occur under one theory—a situation could arise whereby the elements of unjust enrichment are satisfied, but breach of fiduciary duty is not.