On April 28, 2022, Vice Chancellor Slights of the Delaware Chancery Court issued a verdict for the defense in In re Tesla Motors, Inc. Stockholder Litigation, a long-running derivative lawsuit challenging the 2016 acquisition of SolarCity Corporation by Tesla Motors, Inc. While the court found that the acquisition satisfied Delaware’s demanding “entire fairness” standard, it repeatedly chastised Tesla’s board of directors — especially Tesla CEO Elon Musk, the lone remaining defendant at trial — for failing to implement appropriate processes and procedures to address conflicts of interest by board members. Musk thus subjected himself (needlessly, in the court’s view) to the expense and risk of a trial. The case serves as a reminder of the importance of appropriately handling conflicts of interest while considering and negotiating mergers and acquisitions.
Before 2016, Tesla — a leading electric-car manufacturer — had sought to partner with SolarCity — a leading solar-panel installation company — on various projects in furtherance of Tesla’s stated mission to “accelerate the world’s transition to sustainable energy.” In early 2016, Musk asked Tesla’s board to consider acquiring SolarCity. Several of the Tesla board members had alleged conflicts of interest concerning the transaction. Most notable were Musk’s own, obvious conflicts: he was the largest shareholder of both companies, sat on both companies’ boards, and had leading roles at both companies as Tesla’s CEO and SolarCity’s chairman. Other directors also had connections with SolarCity. There was only one Tesla director whose independence could not be “seriously questioned.”
The court found that Tesla had failed to adopted several best practices for addressing these director conflicts:
- Establish a Special Committee of Independent Directors. The court pointedly criticized Tesla’s failure to establish a special committee — a “standard protection” when faced with director conflicts: “The Tesla Board should have formed a special committee comprised of indisputably independent directors, even if that meant it was a committee of one.”
- Conflicted Directors Should Recuse Themselves. The court observed that Musk “should have stepped away from the Tesla Board’s consideration of the Acquisition entirely, providing targeted input only when asked to do so under clearly recorded protocols.” Instead, Musk recused himself from only some board meetings; openly voiced his opinions at meetings he did attend; had direct conversations with Tesla’s managers and financial advisors about the deal; and directly urged stockholders to support an acquisition while negotiations were still ongoing. Musk’s high level of involvement effectively opened the door for stockholder challenges to the acquisition.
- Independent Directors Should Select Deal Advisors. While the court found that Tesla had “independent, top-tier advisors” — a law firm and financial advisor — it noted that Musk “should not have been involved in the selection of counsel to advise the Tesla Board.” A better practice would be to defer to disinterested directors in the ultimate selection of deal advisors.
Nonetheless, the court also found a number of things that went right during the deal process:
- Let Independent Directors and Advisors Lead the Negotiations. Despite the lack of a special committee, Tesla’s disinterested director played the lead role in negotiating the terms of the acquisition. The court also found that, despite some inappropriate contact with Musk, Tesla’s advisors acted independently and effectively in advising the board. The court acknowledged that Musk, despite his imprudent involvement in the process, was willing to let others make the ultimate decisions and “did not push back” against the board’s efforts to obtain the best price for Tesla.
- Create a Record of Hard Bargaining. The court found that Tesla had bargained effectively and at arm’s length with SolarCity. In particular, Tesla had successfully negotiated a lower price when diligence revealed that SolarCity’s was facing a “dire liquidity situation.”
- Consider Holding a Vote of Minority Stockholders. The court also put significant weight on Tesla’s decision to condition the deal on approval by minority stockholders, even though Delaware law did not require that step. The stockholder vote not only supported the fairness of the process despite the infirmities at the board level, but also supported the fairness of the price because the Tesla’s investor base — which included a large number of sophisticated institutional investors who were well informed about both Tesla and SolarCity — voted overwhelmingly to approve the acquisition.
Weighing these considerations, the court ultimately found the evidence “compelling” that the acquisition satisfied the “entire fairness” standard, the most demanding test under Delaware law for evaluating whether directors have discharged their fiduciary duties in mergers and acquisitions. Musk had argued for a lower standard — including by disputing that he was a “controlling shareholder” of Tesla — but the court found it unnecessary to resolve that issue given strong evidence that the process, despite its flaws, ultimately worked and achieve a fair price for Tesla stockholders.
However, the court went out of its way to explain that Musk and Tesla’s board had incurred unnecessary risk and expense by failing to form a special committee and otherwise remove Musk from the process: “There was a right way to structure the deal process within Tesla that likely would have obviated the need for litigation and judicial second guessing of fiduciary conduct.” Tesla’s directors likely could have prevailed on a motion to dismiss or summary judgment, without the need for an expensive and disruptive trial, had the appropriate measures been followed. The court not only denied Musk’s requests for attorney’s fees, but also took the unusual step of denying him prevailing party costs — which are routinely awarded in most cases — because he “likely could have avoided the need for judicial review of his conduct as a Tesla fiduciary had he simply followed the ground rules of good corporate governance in conflict transactions.” Accordingly, the decision should serve as a reminder that failing to handle conflicts appropriately can lead to significant risk and expense even when mergers and acquisitions are in the best interest of the company and its shareholders.
Justin Ward, an author of this Client Alert, is only admitted in New York.
Caroline H. BullerjahnPartner
Lisa R. HaddadPartnerCo-Chair, Public M&A / Corporate Governance
Joshua M. ZachariahPartnerCo-Chair, Technology M&A
Justin D. WardAssociate