What does a guy have to do to get his $56 billion paycheck?

On Monday, Delaware Chancery Court Judge Kathaleen St. J. McCormick once again struck down Tesla’s $56 billion pay package for CEO Elon Musk, doubling down on her decision from January, despite Tesla’s shareholders overwhelmingly approving the company’s ratification. In response, Tesla (and Musk) took to X to announce that they would appeal the ruling.

A brief summary of how we got here:

In 2018, Tesla’s board and shareholders agreed to an ambitious compensation package for Musk. To quote the judge’s January opinion:

“He envisioned a purely performance-based compensation plan, structured like the 2012 Grant but with more challenging market capitalization milestones and proposed 15 milestones of $50 billion in market capitalization—a total possible award of 15% of Tesla’s outstanding shares. To put Musk’s proposal in perspective, each market capitalization milestone increase of $50 billion required Tesla to grow in size roughly equal to the market capitalizations of each of Tesla, Ford, and GM as of early 2018. So, Tesla would have to grow an amount in market capitalization equal to that of the most significant domestic car manufacturers for Musk to earn a single tranche of compensation. Musk viewed this proposal as ‘really crazy.’”

Musk and the board eventually agreed on 12 vesting tranches in $50 billion increments instead of 15, and 16 operational milestones based on revenue and adjusted EBITDA performance. The pay package was approved, with 73% of voting shareholders in favor of the pay package, but retail shareholder Richard J. Tornetta filed a derivative lawsuit with four claims:

1. A breach of fiduciary duty by Musk in his capacity as a controlling stockholder;

2. A breach of fiduciary duty by the directors;

3. Unjust enrichment against Musk;

4. Waste.

The fourth claim was dismissed, but the other three weren’t, with the judge ruling in Tornetta’s favor. The entire opinion is 200 pages long (you can read it here), but the crux of the issue, which led the judge to rule in favor of Tornetta, was the conflict of interest between Musk and the board, the lack of a counteroffer to Musk’s ambitious ask, and the lack of disclosure to shareholders. To quote the opinion:

“The Proxy failed to disclose any of the Compensation Committee members’ actual or potential conflicts with respect to Musk…

The description of the Compensation Committee members as ‘independent’ was decidedly untrue as to Gracias and proved untrue as to the remaining committee members. At a minimum, Musk’s relationships with Ehrenpreis and Gracias gave rise to potential conflicts that should have been disclosed. Ultimately, all of the directors acted under a controlled mindset, calling into question the disclosure as to each of them…

Defendants argue that disinterested stockholder approval is ‘compelling evidence’ that the price was fair. The stockholder vote is one component of the fair price analysis, but whether the vote represents a form of market evidence that can support a certain price depends on the sufficiency of the disclosure. Generally, a stockholder vote is only ‘compelling evidence’ of fairness absent a disclosure violation.”

Basically, given Musk’s 21.8% stake in Tesla at the time of the deal, along with his relationships with the board, he was viewed as a “controlling stockholder.” Under Delaware law, the compensation committee was subject to review the compensation under the “entire fairness standard,” and it had to prove that the transaction was approved by a fully informed vote of the majority of stockholders. 

The judge argued that the vote couldn’t have been fully informed due to the lack of disclosures of long-standing ties between Musk and members of the Compensation Committee, several of whom were invested in other Musk ventures and had established relationships with him. Additionally, the fact that the compensation committee never once countered Musk’s $56 billion compensation package request (in fact, it was his idea to reduce it from an even larger grant) highlighted that Musk likely had undue influence over the Committee. Ultimately, the judge ruled that the shareholders couldn’t have made an informed vote and ruled the compensation package invalid. 

On one hand, she raised valid points about the conflicts of interest, but on the other hand, Tesla’s stock price increased by 20x during the time of that stock grant, and Musk should have been rewarded accordingly. What Tesla did between 2018 and 2021 was nothing short of insane.

So, Musk moved Tesla’s incorporation from Delaware to Texas, and Tesla issued a revote with shareholders to ratify the pay package, which easily passed. The issue, however, was that none of this changed the underlying issue: there was a conflict of interest involving the Compensation Committee that determined the judge’s ruling, and a shareholder vote after the judge issued her ruling wouldn’t retroactively change the rule.

Now, what Tesla could have done was move its incorporation and revote on a new package to pay Musk the full amount at current prices. It would have been the same dollar amount of stock issued, but the company didn’t want to do that because it would create accounting charges “in excess of $25 billion” stemming from stock-based compensation. 

Despite the fact that the dilution would be identical, the earlier package would create a lower earnings hit due to the lower stock price at the time of the deal used to assess the “fair value” of the grant. Additionally, as reiterated in the judge’s new opinion, she didn’t rule that Musk shouldn’t have received a new pay package, but that the board didn’t prove that the terms were fair to shareholders, and, frankly, they didn’t negotiate on the terms at all.

Now, that’s not to say that the judge’s language didn’t imply some level of bias. For example, her first opinion opens with, “Was the richest person in the world overpaid?” and she noted that “this decision dares to ‘boldly go where no man has gone before,’ or at least where no Delaware court has tread,” showing that, at a minimum, she appears to take pride in this decision.

However, at the end of the day, while Tesla’s shareholder vote showed that investors favored Musk’s pay package, it couldn’t retroactively alleviate the ruling. My two cents, if Tesla loses its appeal, is to simply vote on a new pay package that grants him the equivalent amount of stock, instead of trying to overrule a judge’s decision on a package from six years ago. Yes, the earnings hit would be higher on paper, but the actual cash and equity impact would be identical either way.