Elon Musk Pay Deal Voided - Should Tesla Reincorporate in Texas?
A Delaware court this week voided Elon Musk’s $55.8 billion dollar pay deal with Tesla. The voiding of these stock options erases about a quarter of Musk’s current wealth. The judgement came in response to a shareholder lawsuit launched by Richard Tornetta who owned nine shares in the company.
The complaint argued that Tesla’s board of directors breached their fiduciary duties to investors in the company in the way Musk’s equity-compensation plan was awarded. The Court ordered Tesla to cancel the stock options meaning that the company’s directors now have to come up with a new compensation plan for Elon Musk that meet legal standards and keep Musk, who recently demanded that the board substantially increase his ownership – or at least control - of Tesla happy. This judgement questions the quality of governance at Tesla, and it’s likely that the company will need new independent directors who can be seen to represent shareholder interests and provide oversight of the management of the company, rather than representing Musk’s interests alone. Any new compensation package awarded to Musk to replace the voided pay deal would have to be shown to have been put together in an arms-length negotiation between independent directors and Elon Musk. Right now, it seems likely that any replacement pay deal might be a lot lower than the contract being replaced, and it might also include provisions requiring Musk to devote more of his time to managing Tesla rather than his other business interests.
The decision can be appealed to the Delaware Supreme Court, so it is not yet set in stone, and Elon Musk announced yesterday that he will seek to incorporate the company in Texas, a state that he believes could be more hospitable to his way of doing business than Delaware. We’ll dig into that topic near the end of the video. So, let’s discuss why a court gets to opine on a CEO’s pay package at all? Why Elon Musk lost this case, why many Tesla investors are unhappy – even if they are the winners, how executive compensation grew to the levels we see today, why are so many US companies incorporated in Delaware and is Elon Musk right to shift Tesla’s incorporation to Texas? We will also discuss the fact that the lawyers who won this case may end up taking as much as 19 billion dollars of the investors winnings as a fee – which would be by far the highest fee ever awarded to plaintiffs’ lawyers in the Delaware chancery court history. OK, so first up, why did a court even get to assess the fairness of Elon Musk’s pay package? Well, under normal circumstances, a court would not get involved in a dispute like this. Delaware is a very pro-business jurisdiction, a key concept in Delaware law is the “business judgment rule,” which recognizes that judges – whose expertise is in law and not business - should not second-guess business decisions made by directors in good faith and with due care— even if the decisions turn out to be bad ones. That very rule is the reason that Elon Musk got away with Tesla’s controversial purchase of Solar City.
According to Judge Kathaleen McCormick’s post trial opinion, “A board of director’s decision on how much to pay a company’s CEO is the quintessential business determination subject to great judicial deference” – so the courts wouldn’t typically get involved in this. She then goes on to clarify that Delaware law recognizes unique risks inherent in a corporation’s transactions with its controlling stockholder. She gives the examples of Mark Zuckerberg, Jeff Bezos and Bill Gates saying that a transaction with a founder/CEO like that could be viewed as self-dealing and is assessed under a complex set of legal standards if it is challenged in court by an investor. The court decided that Musk was a controlling shareholder of Tesla for the purposes of setting his compensation package. This decision was based on the fact that he owned 21% percent of the company at the time, and that he could “exercise outsized influence in the board room” due to his close personal ties to the directors and his “superstar CEO” status.
McCormick highlighted that Musk structured the pay package and proposed it to the board, Musk controlled the timelines of the board’s deliberation, and he received almost no pushback at all from the directors. According to the opinion, and the directors own testimony, board members and Tesla’s general counsel seemed to view themselves as participating in a cooperative process to set Musk’s pay, rather than an adversarial one. There was no pushback against any of his requests.
According to McCormick, Multiple aspects of the process reveal Musk’s control, including the timeline, the absence of negotiations over the magnitude of the Grant or its other terms, and the committee’s failure to conduct a benchmarking analysis. In the end, the key witnesses said it all by effectively admitting that they did not view the process as an arm’s length negotiation. Now there was of course a shareholder vote as well, so why did that not hold up? Well, Before we dig into that let me tell you about todays video sponsor. brilliant.org is the best way to learn math data science and computer science interactively
through their user friendly app brilliant has thousands of lessons from foundational and advanced math to AI data science neural networks and more with new lessons added monthly I've recently been enjoying their statistics and computer science courses brilliant is built for busy people you tell them how much time you want to spend on the app every day and the app then works out your skill level and customizes content to fit your needs I'm told it's six times more effective learning with an interactive app than just watching a lecture whether you're learning math computer science or data analysis brilliant thousands of bite-sized interactive lessons help you master key Concepts and build to more advanced topics to try everything brilliant has to offer free for a full 30 days visit brilliant.org Patrick or click on the link in the video description the first 200 of you to sign up will get 20% off of brilliant's annual premium subscription So, what about the shareholder vote? Musk’s compensation package was put to the shareholders, and 81% of the shares voted in favor. Well, McCormick says that this could have been fine.
In a situation where the directors are not sufficiently independent, the burden can be shifted to the shareholders to decide on the fairness of a compensation package, but only if they are fully informed, which in this case they were not. The court found that the proxy statement delivered to shareholders contained material misrepresentations and omissions, describing the compensation committee as being independent when it was made up of parties with close personal ties to Musk, and didn’t accurately describe the manner in which the pay package was set – with Musk proposing the structure and the board going along with him. The solution to a conflict like this according to McCormick was – quite simply - disclosure. The Proxy could have discussed the relevant relationships between various board members and Musk while stating that the board did not view them as being serious impediments to independence, thereby allowing stockholders to make their own assessment. She goes on to say “What the defendants were not free to do was to take the position that the stockholders had no right to know this information because they, the defendants, had determined it was not important.” So essentially the bad corporate governance at Tesla is the reason that the court was allowed to assess the fairness of Musk’s compensation package.
Now, defenders of Musk’s pay package would point out that it was worth paying Musk $55.8 billion dollars if he increased Tesla’s value from $60 billion dollars to $650 billion dollars. It is a huge pay package, but it’s also a lot of shareholder value to add. The judge looked at comparable CEO pay packages and noted that as large shareholders in the companies they had founded Zuckerberg, Bezos and Gates – just like Musk, all owned significant portions of the companies that they had founded and that their preexisting ownership stakes provided sufficient incentive to grow the companies that they had built.
Musk owned 21.9% of Tesla (which is more than he owns today) at the time of the options grant. If the directors goals were retention, engagement and alignment, then Musk’s preexisting equity stake already provided a powerful incentive for Musk to stay and grow Tesla’s market cap. Judge McCormick highlights in her post-trial opinion that the options grant that Musk received was 250 times the median peer CEO compensation and more than thirty times greater than its nearest comparable plan, which was Musk’s 2012 plan. In the opinion, McCormick asks if encouraging Musk to prioritize Tesla over his other ventures was so important to the directors, why did they not place any guardrails in place on how much time or energy Musk had to put into Tesla to receive this huge payday? So, will this judgement stand? Well, Stephen Wilmot in The Wall Street Journal argues that Tesla could appeal the ruling to the Supreme Court of Delaware.
Alternatively, it could just take the deal back to minority shareholders with a more explicit set of disclosures regarding Musk’s role in influencing it. The company has a large base of retail investors, many of whom are huge Elon Musk fans – you can tell that from their blue ticks, they might vote to give him all of the stock he is asking for. So where did the huge CEO pay packages which led to Elon Musk’s historic options grant come from? Well Roger Lowenstein included an excellent history of executive compensation in his 2004 book about the bursting of the dot com bubble “Origins of The Crash” From 1965 to 1976, the US stock market went sideways, and after adjusting for inflation, equity investors were down over that period.
Americans began to lose interest in the stock market over that time, and the number of Americans who owned stocks declined year after year. By 1979, of the money managed by pension funds, 90% was in bonds bills and cash. The big stock market YouTubers of the day went back to talking about real estate. In this era of underperformance, most corporate executives only owned a scrap of stock in the companies they managed, and they don’t appear to have overly concerned themselves with the stock performance, instead they focused on building huge conglomerates through acquisitions that did little to benefit their shareholders but gave them large empires to oversee. CEO’s of this era focused on stability rather than growth, as stability kept them in comfortable well paid jobs. By the end of the 70’s these large, lazily managed conglomerates were becoming uncompetitive with foreign upstarts.
Detroit had seen its share of the world auto market fall from 75% in 1950 to 20% by the end of the 70’s. Due to a general lack of interest in the stock market, American stocks had become quite cheap which led to the emergence of the hostile takeover. Corporate raiders in the 1980’s began buying up whole companies to extract value.
The emergence of junk bonds on Wall Street meant that these raiders could finance the purchase with borrowed money. Suddenly CEOs began to worry about their company being taken over and losing their jobs. The best defense was to begin thinking about shareholder value and focus on pushing up their stock prices. In some cases, managers even took a leaf out of the corporate raiders books and did a Management Buyout, taking the company private themselves.
In 1990 Michael Jensen, a Harvard Professor and his coauthor Kevin Murphy argued in the Harvard Business Review that boards needed to revamp the way CEOs were paid. The management buyout had shown that when managers thought more like owners rather than like employees, businesses were run more efficiently. The problem according to Jensen and Murphy wasn’t just how much management were paid, it was how they were paid.
They argued that corporate America paid its most important leaders like bureaucrats. The way to get them to act less like bureaucrats was for them to own a substantial amount of stock. Since most CEO’s couldn’t afford to buy big chunks of stock in the companies they were hired to run, this meant that they had to be paid with stock options. At this point, stock prices had already started rising from the doldrums of the 70’s and many CEO’s started asking for some of their compensation in the form of stock options. Investors were delighted to pay them this way as it better aligned management incentives with shareholders.
Silicon Valley was at the front of this trend, and Intel was one of the pioneers who made paying management with options central to their culture. Intel was a hugely successful firm and soon companies like Oracle, Sun Microsystems and Microsoft followed in their path. In 1993 Bill Clinton passed a law to ban tax deductions on salaries above a million dollars.
This new law added fuel to the fire of executive compensation, as stock options weren’t covered under the cap. Boards interpreted the rule change as encouragement to grant more options. Compensation consultants really ran with the ideas put forth by Jensen and Murphy. According to Jensen, the factor that mattered the most was the percentage of a company’s outstanding shares that the CEO owned. He pointed to Warren Buffett as an example who owned 45% of the public company that he managed – Berkshire Hathaway.
Jensen overlooked the fact that Buffett had not been granted that share ownership, he had bought it with his own money. When Lou Gerstner was given half a million stock options in 1993 - to turn around IBM, (a massive options grant at the time) investors applauded, and the business press argued that it would be good for IBM’s stock. During this period, American public companies were reinvigorated. Only a few years earlier it had been accepted wisdom that Japan with their superior manufacturing ability and management culture would overtake the United States. Now in the 1990’s Japan was sinking and American businesses were innovating and growing like never before. The 1990’s also brought the 401k as a new form of retirement plan, which meant that ordinary workers had money in the stock market and cared about corporate performance.
American CEO’s were beholden to investors and to the markets as never before. Shareholder value was the term of the day and executives intent on managing their stock price became obsessed with quarterly earnings. In the mid 1990’s the role of finance within corporations became suddenly elevated, as CFO’s came up with innovative approaches to making their stocks more attractive to investors. If CEO’s having some stock had transformed American business this much, what would giving them even more stock do? By now American corporate executives were the best paid in the world, and their pay was being decided by Boards of Directors often made up of their friends, or other CEO’s – who could use their high pay to demand better pay for themselves. Compensation consultants were brought in to help decide on management pay, and their incentive was to get compensation as high as possible, as that is how they would get other consulting gigs. Often the consultants’ pay was calculated as a percentage of the package paid to the CEO.
The idea went around, that if a company think of itself as a company in the top quartile of American Businesses, shouldn’t their CEO’s pay be in the top quartile too? Executives were now competing to be seen as the top paid in their industry group, or overall. Roger Lowenstein describes how CEO’s really started to clean up on options grants at this time using the example of Nelson Peltz who took control of Triarc companies in 1993 and immediately paid himself with options on 600,000 shares. The next year the stock price fell and Peltz was paid an additional 75,000 options at the new lower stock price. A month later at an even lower stock price he paid himself 2.1 million options. To demonstrate that he was not being greedy he took a salary of only one dollar a year – which was below minimum wage at the time.
Unfortunately for Peltz, the stock price halved once more, and in order to keep himself motivated and aligned with shareholders, he paid himself an additional 240 thousand options and then another 150 thousand. Peltz’s received five options grants over the span of two years during which the stock price fell. Some of these options were even granted at 85% of the stock price at the time of the grant, meaning that the stock price didn’t even have to rise for Peltz to be rewarded. Now although Peltz had forgone pay, other than a dollar a year, he did get paid a cash bonus of $2 million dollars (which was above minimum wage) in 1996.
After all, man cannot live on stock options alone. This bonus was awarded for paying down debt, selling assets, restructuring and other activities that some might argue were simply part of his job description as CEO. By now the stock was down 36%. While the stock had performed horribly (at a time that the stock market was rising), any pop in price even if the price never returned to break even for investors would make Peltz extremely rich. In 1994, Ken Lay of Enron – possibly inspired by Peltz’s mega grant the prior year, negotiated a comparable options award. Michael Eisner at Disney got options on 8 million shares, Henry Silverman of Cendant got 14 million and Bernie Ebbers of WorldCom established the record (at the time) of getting mega grants five years in a row.
These options grants allowed CEO’s to adopt the role of risk takers, without really putting up any of their own money. To quote Lowenstein, CEO’s with up and down records became bizarrely wealthy thanks to their ability to sow annual crops of options and harvest them over short term intervals. This was in no way beneficial to shareholders. For an incentive to work, there needs to be a prospect of pain as well as gain, but with these deals, the only question was how big the gain would be? Over a thirteen-year stretch at Disney, Michael Eisner collected more than $800 million dollars during which time his investors earned less than a Treasury bond return. To quote Lowenstein, “Never has a CEO reaped such a fortune from such prolonged mediocrity.” At this point executives like Ted Turner, Sumner Redstone, Michael Dell and Larry Ellison who already owned billions of dollars of stock in the companies they had either founded or built up began paying themselves mega grants too – I guess to better align themselves with shareholders.
Bill Gates was a notable exception, he received no options grants himself from Microsoft, his founders stake in the company was enough to motivate him, but he did pay other Microsoft employees with options. The huge options grants that founders paid themselves in the 1990’s set the precedent for Elon Musk’s Giga grant of options from Tesla. It is worth noting – as pointed out in the recent Common Sense Sceptic video, that Musk with his giga grant has extracted billions more from Tesla than the company has ever earned in profit in its entire history. In fact his Tesla pay is more than all of his companies have earned in profit in their entire existance. While 1990’s CEO’s were now hyper focused on the stock price, they were possibly too focused on finding every trick possible to pump the stock price up regardless of business conditions. Lowenstein highlights Lucent Technologies which was spun off from AT&T in 1996.
The stock rocketed from $9 to $75 that year alone. It was thought to be one of the fastest growing big companies in America at the time but was actually just using every revenue enhancing trick imaginable. The company later turned out to not really be growing at all, just managing the numbers to keep up with Wall Street’s growing expectations.
In 2000, Lucent’s incoming chairman was alarmed by the companies’ accounting practices. In November 2000, Lucent disclosed to the SEC that it had a $125 million dollar accounting error for the third quarter of 2000, and by December 2000 it reported that it had overstated its revenues for its latest quarter by nearly $700 million dollars. After a series of scandals, by 2002, the stock price had bottomed at 55 cents a share, down 94% since its launch seven years earlier. Scandals at firms like Enron, Tyco, Worldcom, Xerox and a variety of others in the early 2000’s highlighted a problem with paying managers in options, the compensation structure encouraged a focus on short term pumping of the stock at the expense of taking a long-term view.
The number of companies forced to restate earnings because of accounting errors rose from a handful in the 1980’s to more than 150 a year by the late 1990’s. In 2001 – Michael Jensen whose ideas had spurred the mega grant culture of the 1990’s highlighted some of the problems of paying executives in options in his paper “Paying People to Lie.” While aligning executives’ incentives with those of equity investors had reinvigorated American business culture and had driven huge growth since the stock market doldrums of the 1970’s, too much of an emphasis on stock price alone had by the late 1990’s driven crooked executives like Dennis Kozlowski to engage in fraud to push the stock price higher. In the late 1990’s Tyco began ordering dealers for ADT Security Services – one of their subsidiaries to venture into drug infested slums to sign up “any customer with a pulse” for their security systems, regardless of the customers’ ability to make even one payment. This was full on fraud, to pump the stock price.
It is not obvious how best to pay executives like Elon Musk, whose attentions are torn between the multiple companies he owns. As Aswath Damodaran noted in his recent video where he valued Tesla stock, a lot of the value of the company comes from having Elon Musk as its leader. To quote Liam Denning from Bloomberg Musk is both Tesla’s “chief asset and chief risk; it being hard to imagine Tesla being valued anywhere near $600 billion dollars without him”. Musk tweeted a few weeks ago that he wanted to be given a 25% stake – or equivalent voting rights in Tesla — from his current 13 per cent in order to develop its AI products.
He would already have that ownership stake had he not sold a lot of his Tesla stock near its all-time high in recent years. He doesn’t appear to be suggesting that he will buy any of his shares back either... Matt Levine pointed out earlier this week that regardless of his compensation, Musk has good reasons for doing his next good idea at Tesla. It’s the biggest of his companies, so it has a lot of capacity to do things. It’s the largest portion of his fortune, so increasing its value does the most for his wealth. It’s the most liquid portion of his fortune — as he can sell or borrow against Tesla shares much more easily than the rest of his companies — so increasing its value does the most for his practical buying power.
It’s the company with which he is, still, probably, most associated with in the public imagination, so doing stuff at Tesla probably does the most for his reputation. I would add to that that it is the only one of his companies that is profitable, so is not obvious why he would want to walk away from Tesla. Musk announced in the wake of the Delaware judgement that Tesla would “immediately” hold an investor vote on whether to move its corporate registration to Texas. Anne Lipton of Tulane University – an expert on corporate law tweeted that a reincorporation in another state would not affect the outcome of the case. So why was Tesla – which was originally founded in California ever incorporated in Delaware? And does it make more sense for a company to be incorporated in the state where it’s headquarters are located? Well, a lot of companies are incorporated in Delaware, there are in fact more corporations in Delaware than there are people living there.
68% of Fortune 500 companies and 93% of all U.S.-based IPO’s are registered in Delaware. Incorporating in Texas would be unusual for a business the size of Tesla, according to the FT, if Tesla were to reincorporate in Texas, it would be five times larger than all of the Texas-incorporated Russell 3000 stocks combined. There are a few reasons that corporations register in Delaware. Firstly, corporations that don’t do business in Delaware – but are registered there don’t have to pay corporate income tax. This is not the case in other states. While companies do have to pay a franchise tax to register in Delaware, this is capped at two hundred thousand dollars per year.
If Tesla were to reincorporate in Texas they would have to pay 0.75% of revenues per year in franchise tax to the state, which comes to considerably more than two hundred thousand dollars, and it would be difficult to explain this decision to most investors. A big reason that Delaware is an attractive place to register a business is that they have a specialized court that hears corporate law disputes, the Delaware Court of Chancery. The judges on that court are experts in corporate law, they understand the issues, their decisions are seen as being predictable as they are based on over 100 years of Delaware legal precedent. They also understand that these cases can be time-sensitive and move quickly. In other states, cases can be decided by juries – who are less predictable and can take years before being heard.
In Texas, corporate law disputes are often pushed out to make room for criminal cases. For these reasons even foreign companies come to Delaware to have corporate disputes decided. There are numerous academic papers that discuss the “Delaware Advantage” and argue that being incorporated in Delaware can add value to a company. For most companies, it would be seen as a red flag to change incorporation to a less shareholder friendly state, but that does not mean that Tesla investors won’t vote for it.
According to a Reuters article, legal experts say that Musk would open himself up to further investor lawsuits if he tried to move the state of incorporation to Texas, particularly if it was seen as a move to secure his pay package rather than obtain some benefit for Tesla. So he should come up with a good story for why he is making the change. OK, so finally, to what extent will Tesla investors benefit from Elon Musk’s options being voided? The options being voided – go back to shareholders, right? Well, while this ruling is likely to put a dent in Elon Musk’s net worth, he won’t likely lose the full 55.8 billion dollars as the board is likely to come up with a new pay package for him that meets the legal requirements, and we don’t yet know what that might be.
Any new pay package, that is negotiated by a competent board, might require Musk to spend more time at Tesla rather than on his other business interests, and that is likely to make Tesla investors happy. This time around, Tesla and Musk need to make sure that shareholders get a fully informed opportunity to pass judgment on the plan. The Financial Times pointed out yesterday that the lawyers who represented Tesla shareholders may receive a record-breaking payout possibly worth billions of dollars based on this victory. That payout would come from Tesla shareholders.
The law firm is allowed to request up to one third of the benefit conferred by the ruling, which would come to 19 billion dollars. This would have to be approved by the Delaware Chancery Court, and a payout that large being approved is unlikely. The largest payout ever awarded to lawyers in Delaware history was $285 million dollars, which was around 15 per cent of the damages in the lawsuit in question back in 2012. Whatever the size of the payout, it is likely to set a new record. If you found today’s video interesting, you should watch this one next.
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