The Delaware Chancery Court’s decision to rescind Elon Musk’s $55.8 billion Tesla pay package drew considerable attention because of its size, but it could also demonstrate the willingness and ability of courts to scrutinize extraordinary grants. The court noted that, as founder and chair, Musk was a “Superstar CEO” who had received “the largest compensation plan in the history of public markets.”
“Business Judgment” v “Entire Fairness:” In deciding shareholder challenges to executive pay, courts typically defer to companies by applying the “Business Judgment” rule, which avoids second guessing unless the plaintiff can show that the directors who made the decision are not sufficiently independent and disinterested, and/or did not exercise well-informed due care.
In the Tesla case, the Court found that the directors were not sufficiently independent due, in part, to Musk’s 21.9% equity in the company, “thick ties” between Musk and the directors, the failure to use benchmarking, and a shareholder vote that omitted details about the process and lack of independence among key directors.
Under the more rigorous “Entire Fairness” doctrine, which the court applied, the Court found the directors failed to show that the extraordinary amount – tied to the growth of the company – was either a decisive element in that growth or necessary to retain Musk.
Dr. Tharp’s prescription: Dr. Charles Tharp, Executive Vice President of HR Policy Association and Senior Advisor, Research and Practice of its Center On Executive Compensation notes, “The Court’s decision demonstrates that judicial deference to compensation committee pay decisions is contingent upon the committee following good governance processes, the absence of conflicts of interest, and the demonstrated reasonableness of the quantum of pay.”
What’s next? Given the astonishing amount of pay involved, and the uniqueness of the company and its founder, it is too early to predict whether the case is a turning point in the traditional judicial deference to compensation committees. Yet, the notoriety of the case could prompt more challenges by shareholders through both proxies and derivative suits, which could eventually lead to increased application of the severe “Entire Fairness” doctrine.