A challenge to a transaction between a Delaware corporation and its controlling stockholder generally will be subject to the highest level of judicial review—“entire fairness”.  As a result, a critical factual question often is whether a significant, but minority, stockholder could be viewed as controlling the corporation.

In a recent decision,[1] the Delaware Court of Chancery (the “Court”) concluded that it was reasonably conceivable that Elon Musk, the founder and the owner of 22.1% of the stock of Tesla, Inc. (“Tesla”), was a controlling stockholder of Tesla and controlled Tesla’s board of directors in connection with its decision to acquire (the “Acquisition”) SolarCity Corporation (“SolarCity”), another company founded by Musk and his cousins and of which Musk owned 21.9% of its stock.  As a result, the transaction could be subject to the heightened entire fairness standard of review notwithstanding that it was approved by the holders of a majority of Tesla’s disinterested shares.

The Tesla Decision

The Court made its determination based on a facts and circumstances analysis that a combination of the following enumerated factors satisfied plaintiffs’ limited pleading burden at the motion to dismiss stage.[2]

Musk’s Voting Influence

The Court acknowledged that Musk’s 22.1% ownership was “relatively low”, but stated that a “linear, sliding scale approach” does not apply to controller determinations and the Court could consider other indicia of control.[3]  In this regard, the Court noted plaintiffs’ allegation that Musk had previously been willing to remove senior management when displeased and that history could have influenced Tesla’s board of directors to align itself with Musk to ensure he remained satisfied with the individual directors’ performance. Moreover, Tesla’s bylaws contained several supermajority voting provisions, including with respect to certain mergers, acquisitions or changes to the Tesla board’s compensation or composition, which meant that with respect to such matters Musk’s 22.1% ownership should be evaluated based not upon a 50% voting majority but against a 66.67% voting supermajority standard (effectively increasing Musk’s ability to block or influence voting determinations for such matters).  The Court also noted that Musk might have outsized influence on other stockholders if it is accurate that public investments in Tesla reflect an investment in Musk and his vision for Tesla’s future.

Musk’s Control Over the Tesla Board

The Court focused on the Tesla board’s process in approving the Acquisition when considering Musk’s influence over the board.  The Court noted that Musk was not completely separated from the board’s decision-making process with respect to the Acquisition.[4]  Musk brought the proposal to the board on three separate occasions and led the board’s discussions and engaged the board’s advisors with respect to the Acquisition.  Plaintiffs’ complaint also alleged that Tesla’s board never considered forming a special committee of disinterested, independent directors to evaluate the Acquisition.

The Court further reasoned that Tesla’s board must have been aware of Musk’s role in assisting Tesla through difficult times and serving as its visionary generally, for example through recruiting executives and engineers, contributing to the Tesla Roadster’s engineering and design, providing capital infusions to Tesla and setting forth his “Master Plans” for the company, which included the Acquisition.  Interestingly, the Court contrasted Tesla’s process with the steps taken by Michael Dell in connection with the recent management buyout of Dell, Inc., in which Michael Dell took overt steps to avoid “dominating” the corporate decision-making process and thereby assisted the court in resisting the “instinctive appeal” of the “face of the company” argument when evaluating the status of an alleged controlling stockholder.[5]

The Tesla Board’s Conflicts

The Court also concluded that it was reasonably conceivable that a majority of the five members of Tesla’s seven-member board who approved the Acquisition (Musk and another board member who also served concurrently on SolarCity’s board recused themselves) were interested in the Acquisition or not independent of Musk.  With respect to two such directors, the Court noted that Tesla’s SEC filings conceded they are not independent.  The Court determined that the third director’s ten-year service on Tesla’s board, Musk’s gifts to the director of the first Tesla Model S and second Tesla Model X and the frequent investing relationships between Musk and the director (including the director’s ownership, personally and through his affiliated venture capital fund, of SolarCity stock) permitted the inference that the director was beholden to Musk and may not have acted independently in approving the Acquisition.[6]

Tesla’s and Musk’s Acknowledgement of Musk’s Influence

The Court also noted that, although no express concession was made by Tesla or Musk that Musk is a controlling stockholder, Tesla’s public filings disclose Musk’s significant contributions to Tesla and Tesla’s dependence on Musk and that the concentration of ownership among Tesla’s existing directors and officers and their affiliates could prevent new investors from influencing significant corporate decisions.[7]  The Court also observed that Musk had previously asserted that Tesla, SolarCity and SpaceX form a “pyramid” on top of which Musk sits and that Tesla was “his company”.[8]

Key Takeaways

The Tesla decision is notable because of Musk’s relatively low ownership of Tesla and the general process-related allegations which the Court concluded permit an inference that Musk dominated Tesla’s board with respect to the Acquisition.  Key takeaways include:

  • Stock ownership is not the end of the analysis. The Court determined that Musk’s influence over voting matters may be outsized relative to his 22.1% ownership.  In particular, the Court highlighted Musk’s significance to Tesla as a co-founder, source of capital and key decision-maker with respect to both the company’s direction and its hiring decisions.  The powerful identification between Musk and Tesla (which was also noted in public filings and statements) likely was a motivating factor which may have tipped the balance in favor of letting the litigation proceed as the Court otherwise holistically evaluated the plaintiffs’ claims.
  • Process matters. The Court appeared troubled by what it perceived as procedural deficiencies relating to the introduction, and approval, of the transaction.  Musk repeatedly brought the potential Acquisition to the Tesla board’s attention and led discussions and hired Tesla’s advisors to evaluate the Acquisition.  In addition, Tesla’s board failed to recognize their own conflicts or impose protective procedural constraints on the transaction, which would minimize Musk’s influence on the board’s decision-making process.  Finally, the Court seemed generally influenced by plaintiffs’ characterization of the Acquisition as a bail-out transaction benefitting SolarCity and its stockholders (including Musk and certain other Tesla directors and officers) and the Tesla board’s failure to consider alternative solar transactions.
  • Planning. We expect that Tesla will induce caution by Boards considering transactions with one or more large but minority stockholders.  Given the Delaware courts’ recent focus on narrowing the potential paths to successfully challenge a merger transaction, plaintiffs’ lawyers will be increasingly incentivized to seek to convince the applicable court that minority blockholders are controllers to circumvent the cleansing effect of the Corwin decision and prevent their claims from being dismissed under the more board-favorable business judgment standard of review.[9]  As a result—and given the highly contextual factual analysis required to determine whether the stockholder is in fact a controller—in most cases it will be prudent for the Board to plan on the basis that the stockholder is a controller.  This would mean proceeding with the well tested procedures that often are used in such transactions (including establishing fully independent special committees) unless other factors (e.g., deal certainty) indicate otherwise.  Needless to say, the decision as to which procedures should be used should be made at the commencement of consideration of a transaction with full involvement of experienced counsel.

[1] In re Tesla Motors, Inc. Stockholder Litigation, C.A. No. 12711-VCS (Del. Ch. Mar. 28, 2018).

[2] Id. at 56.  The Court began its analysis by noting that plaintiffs could allege controller status by pleading “either (or both) . . . (1) that the minority blockholder actually dominated and controlled the corporation, its board or the deciding committee with respect to the challenged transaction or (2) that the minority blockholder actually dominated and controlled the majority of the board generally.”  Id. at 39.

[3] Id. at 41-42.  Nonetheless, a chart comparing the ownership percentages of minority blockholders and the determination by a Delaware court as to whether they were a controlling stockholder prepared in a pre-Corwin decision reveals that in pre-Corwin jurisprudence, decisions of the Delaware courts typically required ownership of approximately 35% to result in a determination of controller status.  In re: Crimson Exploration Inc. Stockholder Litigation, C.A. No. 8541-VCP, at 35 (Del. Ch. Oct. 24, 2014).  Corwin refers to Corwin v. KKR Financial Holdings, 125 A.3d 304 (Del. 2015), which we previously discussed here and here.

[4] In re Tesla at 46.

[5] Id. at 47.  Among other things, the Court noted that (1) Michael Dell advised Dell’s board he would not proceed with a management buyout without the Dell board’s approval, (2) Dell’s board formed an independent committee to negotiate with Michael Dell and Michael Dell did not participate in any board level discussions regarding a sale of Dell, (3) the committee explored alternatives to Michael Dell’s management buyout proposal, (4) Michael Dell agreed to join another bidder if a superior proposal emerged and (5) Michael Dell entered into a voting agreement to neutralize the impact of his shares in any vote to approve his buyout or any superior proposal.  Id. at 46-47.

[6] The Court further noted, apparently without accepting or rejecting the argument, that plaintiffs alleged that the $2.6 billion purchase price for the severely distressed SolarCity was so one-sided that only a dominated board could have approved the Acquisition.  Id. at 53.

[7] The Court analogized to one of its previous decisions, In re Zhongpin Inc. Stockholders Litigation, 2014 WL 6735457 (Del. Ch. Nov. 26, 2014), in raising these points, although in that previous case the public filings included an express acknowledgement that the alleged controller was a controlling stockholder.

[8] In re Tesla at 55.

[9] Indeed, Vice Chancellor Slights, in a recent decision, referred to this repeated fact pattern and noted that:

“In this post-Corwin, post-MFW world, a pattern has emerged in post-closing challenges to corporate acquisitions . . . where a less-than-majority blockholder sits on either side of the transaction, but the corporation in which the blockholder owns shares does not recognize him as a controlling stockholder and does not, therefore attempt to neutralize his presumptively coercive influence. The pattern, in its simplest form, consists of two elements: (1) the stockholder plaintiff pleads facts in hopes of supporting a reasonable inference that the minority blockholder is actually a controlling stockholder such that the MFW paradigm is implicated and the Corwin paradigm is not; and (2) failing that, the plaintiff pleads facts in hopes of supporting a reasonable inference that the stockholder vote was uninformed or coerced such that Corwin does not apply.”

In re Rouse Properties, Inc., Fiduciary Litigation, C.A. No. 12194-VCS, at 2-3 (Del. Ch. Mar. 9, 2018). MFW refers to In re MFW Shareholders Litigation, 67 A.3d 496 (Del. Ch. 2013), aff’d sub nom., Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014), which we previously discussed here.