A recent decision by Chancellor Kathaleen McCormick of the Delaware Court of Chancery following a five-day trial ordered the rescission of the largest executive compensation package in U.S. history. The decision in Tornetta v. Musk would be newsworthy just for that reason. But the opinion also has important ramifications for companies and their boards when handling transactions with dominant stockholders and when making executive compensation decisions.

The Chancellor notably found Tesla CEO Elon Musk to be a controlling stockholder, despite owning only 21.9% of Tesla. This finding caused the court to conclude that the option grants were a conflicted-controller transaction requiring application of the “entire fairness” standard of review, Delaware’s most stringent form of judicial review. The Chancellor held that the defendants failed to meet their burden to prove that the process employed by the Board in approving the compensation arrangements, as well as the compensatory options, were entirely fair. In particular, the Chancellor was troubled by what she perceived to be the pliancy of the compensation committee, which she found to be comprised of directors with deep financial and personal relationships with Musk, acting “almost as an advisory body” to Musk rather than as an independent negotiator. She twice quotes the Compensation Committee Chair’s testimony that “We were not on different sides of things. We were trying to make sure if we were going to go through this exercise that he was on board.”

The Chancellor faulted the Compensation Committee and the board for not considering alternatives, failing to conduct a customary benchmarking analysis, and not assessing whether the grant was necessary to meet the company’s purposes. She also found that the burden of proving entire fairness remained with the defendants despite a vote of the stockholders approving the grant, because the relevant proxy statement was deficient for failing to disclose, among other things, the relationships of a majority of the board with Musk that called into question their independence and projections showing that the company expected to meet the milestones for Musk’s compensation. Without such information she found the stockholder vote was not fully informed.

Each of these elements of the Tornetta decision bears consideration and analysis beyond the scope of this client alert. Indeed, there may be an inclination to view the opinion as only applying to an entire fairness reviews of conflicted-controller executive compensation transactions. While in a strict sense that may be the case, Tornetta is an important decision on Delaware executive compensation and provides some generally applicable guidance for boards and compensation committees considering executive compensation awards.

1. Document the Process and Maintain Adequate Minutes. Chancellor McCormick emphasized the rushed and informal decision-making of the compensation committee, and the testimony of directors who could not recall meetings where important elements of the stock grant were discussed. More detailed minutes and formal committee and board materials, such as Powerpoint decks and detailed board books, would have reflected the actual process, assisted the directors in their testimony and evidenced the consideration actually undertaken.
2. Conduct a Thorough Analysis, Including an Analysis of Comparables. When considering a significant award boards and compensation committees should undertake a formal analysis of some rigor and thoroughness, which should including benchmarking. As noted above, carefully documenting that process is essential.
3. Clear Rationales Are Essential. According to the court, Musk’s award had no mechanism for ensuring that the award would cause its intended purpose of maintaining Musk’s continuing focus on Tesla rather than his other business ventures. In the Chancellor’s term, the “give/get” was unilateral. Compensation committees should assess whether and how to ensure that significant awards to executives are aligned with the Company’s business objectives.
4. Performance Conditions Need To Be Meaningful and Real. The court further highlighted that performance thresholds for executive compensation awards should be actually incentivizing. The Chancellor was particularly concerned that the financial projections relied upon to approve Musk’s grant actually forecast the achievement of certain vesting milestones. Thus the court noted that the grant was hardly needed to drive performance.
5. Expect Extra Scrutiny of Nominally Independent Directors. Of particular significance to the Court was the fact that Musk had long-standing personal and business relationships with numerous directors of the company, which undermined the process the Board employed in reviewing the grant to Musk. The Court was concerned that these relationships caused the compensation committee members to approach the process as a collaborative process with Musk, rather than an arm’s length negotiation. Expect, when considering significant compensation awards, that all elements of an independent director’s connections with the executive-grantee—including length of board service—may be closely examined for indicia of objectivity.
6. Expect Scrutiny of A Dominant Stockholder as a Possible Controller. The court found that a stockholder’s “domination” of the board during the consideration of a particular transaction, even if his equity holdings are well below 50%, can make him a controlling stockholder for purposes of analyzing the transaction. Once a determination is made that the stockholder is controlling, the Chancery Court will closely scrutinize the independence of directors considering the transaction and look for evidence that the directors acted under a “controlled mindset” more intent on cooperating with the controller than bargaining with him on an arms' length basis.
7. The Compensation Committee Must Act as an Actual Check on Management’s Compensation Expectations. The role of the compensation committee chair and company management was a matter of particular focus in the Tornetta decision. The heavy involvement of management and the reactive nature of the chair created the optics of a dynamic that troubled the Chancellor. An actual negotiation where necessary is an expectation of the Chancery Court. When it is in the best interests of the corporation, the compensation committee and the compensated executive are “on different sides of things.” The expectation that a compensation committee will act as a check on the compensation desires of management should be understood to apply to compensation committees as a general matter, not just those faced with a conflicted-controller in the process.