No Backsies: Tornetta v. Musk Holds That Fiduciary Duty Breaches in a Conflicted Controlling Stockholder Transaction Are Not “Fixed” By A Shareholder Vote

In an important ruling for boards of directors and shareholders alike, Chancellor Kathleen McCormick of the Delaware Chancery Court denied Elon Musk and Tesla’s attempt to reverse her trial verdict rescinding Musk’s 2018 compensation package.[1] After trial, Musk and Tesla’s Board attempted to “ratify” the rescinded compensation package by holding a stockholder vote to “fix” issues raised at trial and to ratify the pay package.  Despite shareholders overwhelmingly voting to ratify the compensation package, Chancellor McCormick ruled that common law ratification could not be used to reverse the trial outcome or “cure” breaches of fiduciary duty in a conflicted controlling stockholder transaction.[2]  The Court sustained the verdict rescinding the $55B compensation package, and awarded Plaintiff’s counsel $345M in fees.  Tornetta shows that courts are unlikely to hold that fiduciary duty breaches in conflicted controlling stockholder transactions can be cured after-the-fact by a shareholder vote, whether the vote occurs before or after trial.
 
Facts
 
On January 21, 2018, the Tesla Board of Directors (the “Board”) held a special meeting to approve Musk’s 2018 compensation award (the “Grant”). The Grant comprised 12 tranches, each of which would vest upon satisfaction of one market capitalization milestone and one operational milestone.[3] Each completed tranche provided Musk options to purchase shares equal to 1% of Tesla’s outstanding common stock as of January 19, 2018.
 
The Proxy Statement for the Grant disclosed a $55.8 billion maximum value and $2.6 billion grant date fair value. Tesla achieved all market capitalization milestones and nearly all operational milestones. By June 30, 2022, all conditions for all 12 tranches to vest had been met and by January 30, 2024, all options under the Grant were fully vested and in the money. Musk never exercised the options.[4]    
 
The Litigation

Tesla stockholder Richard Tornetta (“Plaintiff”) filed the action on June 5, 2018. Plaintiff claimed that Musk breached his fiduciary duties as a controlling stockholder and that the Directors breached their fiduciary duties as directors. In a Post-Trial opinion issued January 30, 2024, the Court ordered rescission of the Grant as a remedy for Musk and the Directors’ breaches of the duty of loyalty. For an in-depth discussion of why the Court found that the duty of loyalty had been breached, please see our previous article referred to in Footnote 1, but the cliff note version is that Musk was deemed to have “transaction specific control” thereby requiring the Directors and Musk to prove the “entire fairness” of the transaction. The Court found that they failed to meet their burden because the “Board capitulated to Musk’s terms and then failed to prove that those terms were entirely fair.”  The Court then ordered rescission of the stock option grants, effectively wiping out all of Musk’s compensation for the period of 2018 through 2022 which was now worth approximately $52B.
      
The Post-Trial Stockholder Ratification Vote

Eleven days after the Court issued its Post-Trial decision, Tesla’s Board formed a special committee to determine whether the “Grant should be ratified” and whether Tesla should re-domesticate and incorporate in Texas. The Board appointed outside directors Kathleen Wilson-Thompson and Joe Gebbia to the committee. Gebba later stepped down due to alleged social ties with Musk and Wilson-Thomspon completed the task of reviewing ratification of the Grant alone. Wilson-Thompson reviewed 2000 pages of documents, interviewed management and directors and completed the job in eight weeks.[5]   
 
Tesla filed a Proxy Statement on April 29, 2024, recommending that stockholders “ratify” the exact same Grant rescinded by the Post-Trial opinion. The Proxy Statement identified a number of reasons why Tesla was seeking ratification, including that a ratifying vote “would preclude Tesla’s re-domestication from being wrongly perceived as being made in direct response to the Tornetta Opinion and with the intent to award Musk compensation in a different jurisdiction that he could not get in Delaware.” 72% of voting Tesla Stockholders, other than Musk and his brother Kimbal, voted in favor of this proposal at Tesla’s annual meeting on June 13, 2024 (the “Stockholder Vote”). Importantly, Tesla made several statements in the Proxy Statement, which materially misstated the legal effect of the stockholder vote.  Tesla claimed that:
 

• A stockholder vote could “extinguish claims for breach of fiduciary duty by authorizing an act that otherwise would constitute a breach.”

 

• “[T]he deficiencies, including disclosure deficiencies, procedural deficiencies, and breaches of fiduciary duty, identified by the Delaware Court in connection with the Board and our stockholders’ original approval of the 2018 CEO Performance Award” would be “ratified and remedied and any wrongs found by the Delaware Court in connection with the 2018 CEO Performance award” would “be cured.”

 

• If the stockholders voted to ratify the Award, the “options will be restored to Mr. Musk” and the Plaintiff in the case “may not be considered to have rendered the ‘benefit’ to Tesla” to support a claim for attorneys’ fees; and

 

• “a new stockholder vote allows the disclosure deficiencies found by the Tornetta court to be corrected.”  (Emphasis added).

 
Similarly, a letter from Tesla Board Chair Robyn Denholm accompanying the Proxy Statement incorrectly stated:

We do not agree with what the Delaware Court decided, and we do not think that what the Delaware Court said is how corporate law should or does work. So we are coming to you now so you can help fix this issue.

The letter also claimed that the Stockholder Vote could “cure” a whole host of maladies “including disclosure deficiencies.”   But, according to the Court, this also misstated the effect of the stockholder vote, which could not – by itself – fix or cure prior breaches of fiduciary duties. Further, Denholm misstated that the Delaware Court “struck down” and “second guessed” the original 2018 Stockholder Vote that approved Musk’s compensation.[6]  Instead, the Court merely held that the prior vote could not shift the burden of proving entire fairness because Defendants withheld material information.

The Chancery Court Rejects Post-Hoc Ratification

However, the Chancery Court rejected Tesla’s ratification argument, because the shareholder vote did not cure the breaches of fiduciary duties.  In rejecting the ratification argument, the Court stated that the argument suffered at least four fatal flaws:

“First, Defendants have no procedural ground for flipping the outcome of an adverse post-trial decision based on evidence they created after trial.”

“Second, common-law ratification is an affirmative defense that must be timely raised, which means that at a minimum, it cannot be raised after a post-trial opinion.”

These first two reasons focus on the absence of any legal basis for a post-trial shareholder ratification of a prior breach of fiduciary duties. Delaware procedural and substantive laws do not provide any basis for a shareholder vote to override a Court’s trial ruling.

“Third, what Defendants call ‘common law ratification’ has no basis in common law. Defendants argue that transactions resulting from breaches of the duty of loyalty can be put to a stockholder vote at any time for any purpose-including to extinguish already adjudicated claims or reverse the outcome of a court decision-because ‘stockholders hold the power to adopt any corporate acts they deem in their best interests’.[7]  That statement is dubious generally and unquestionably false in the context of a conflicted-controller transaction.”

The third reason emphasizes that an after-the-fact vote of disinterested stockholders to approve a conflicted controlling stockholder transaction is not sufficient to cure a breach of fiduciary duty.  Instead, a post-hoc vote merely shifts the burden of proof from the Defendant to the Plaintiff under the onerous entire fairness standard. Tesla was wrong as a matter of law about the legal effect of the vote.

“Fourth, even if the Stockholder Vote could have a ratifying effect on the Grant, it could not here due to multiple material misstatements in the Proxy Statement concerning the effect of the vote. Each of these defects defeat the Ratification Argument.” 

This final reason focuses on Tesla’s material misstatements to shareholders about the legal effect of the vote. The vote would not, as Tesla claimed, “extinguish” the breach of fiduciary duty claims, “remed[y]” or “cure[]”the wrongdoing, or “restore” the stock options to Musk.   Rather, at most, it could shift the burden of proof. Tesla thus solicited the vote using materially false statements, which is an independent basis to give a shareholder vote no legal effect at all. That the Chancery Court strictly scrutinized the Proxy Statement to find material misstatements is a warning that courts will not easily accept the legitimacy of a stockholder vote – even where companies follow the proper procedure by seeking ratification pre-litigation.
 
Conclusion

The decision serves as a stark warning to Delaware corporate boards that they cannot “cure,” “cleanse” or “fix” a breach of fiduciary duty in a conflicted controlling stockholder transaction with a post-trial shareholder vote. Were such a cure allowed, it would completely eviscerate derivative claim litigation because a “perpetrator of fiduciary misconduct could then ‘hit’ the reset through a stockholder vote.”[8] Rather, in the absence of satisfying the MFW doctrine pre-transaction, [9] the “maximum effect of after-the-fact (but pre-trial) stockholder ratification in a conflicted-controller transaction is to shift the burden of proving entire fairness” to the Plaintiff.[10]
 
Should you have any questions regarding minority shareholder rights, partnership or LLC disputes, please reach out to Douglas Hirsch at dhirsch@sadis.com; or Sam Lieberman at slieberman@sadis.com.