Securities Snapshot
May 17, 2022

Delaware Chancery Court Clears Musk of Breach of Fiduciary Duty Claim

Delaware Chancery Court Clears Musk of Breach of Fiduciary Duty Claim; SEC Announces Expansion of Crypto and Cyber-Security Unit; Delaware Chancery Court Denies Summary Judgment to Liberty Broadband and Charter Directors on Stockholder Challenge to Merger between Time Warner and Charter; Delaware Judge Rules that Cryptocurrency Compensation Should be Treated as a Security in Contract Breach Case; Twitter Stockholder Files Suit to Delay Musk Takeover.

On April 27, 2022, the Delaware Court of Chancery in In re Tesla Motors Stockholder Litigation rendered a post-trial verdict finding for Elon Musk, co-founder and CEO of Tesla Motors, Inc., on claims that Musk breached his fiduciary duties, was unjustly enriched and created corporate waste in connection with Tesla’s 2016 acquisition of SolarCity Corporation.

The high-profile litigation arises out of alleged conflicts of interest created by Musk’s leadership and ownership of both companies during the 2016 acquisition: a stock-for-stock merger valued at approximately $2.6 billion. At the time, Musk was the Chairman of the SolarCity board of directors and the company’s largest stockholder. He was also serving as CEO and a director of Tesla, and owned 22% of Tesla’s stock. Tesla elected not to form a special committee of independent directors to negotiate the transaction, and instead conditioned the approval on the “affirmative vote of a majority of the minority of Tesla’s disinterested stockholders” and recused Musk from certain Board discussions regarding the acquisition. Even so, plaintiff shareholders alleged that Musk caused Tesla’s board to approve the acquisition at an unfair price, following a highly flawed process, in order to bail out Musk’s floundering investment in SolarCity. Plaintiffs brought claims against both Musk and members of Tesla’s board seeking damages and equitable remedies. All defendants other than Musk settled with plaintiffs, and Musk proceeded to trial on the claims in July and August 2021.

In the 11-day trial, the court heard evidence regarding the sales process, Musk’s role as a Tesla shareholder, whether the majority of the Tesla board was conflicted with respect to the acquisition by way of self-interest or lack of independence, and the fairness of the sales price. In its 132-page post-trial decision, the court reviewed that evidence to determine the level of scrutiny to apply to the breach of fiduciary duty claim — the lenient business judgment rule, or the much stricter entire fairness standard. The court ultimately determined that, notwithstanding the “provocative questions” regarding the business judgment rule that “could be debated at even the most fashionable corporate law conferences,” to “skip to entire fairness” because “[w]hether by virtue of [Musk’s control], or by virtue of irreconcilable board-level conflicts, there is a basis for assuming that entire fairness is the governing standard of review.”

The court went on to find the acquisition to be entirely fair notwithstanding certain issues in the sales process, primarily because the price Tesla paid for SolarCity — the “preponderant consideration in entire fairness review” — was fair. With respect to process, the court found that any control Musk may have attempted to wield in connection with the acquisition was effectively neutralized by the Tesla board’s focus on the bona fides of the acquisition as led by an indisputably independent director. The court identified several instances where Musk was permitted to participate in the deal process to an inappropriate degree, including by communicating with SolarCity’s management about the acquisition, pressing the Tesla board to consider the acquisition, directing Tesla’s CFO to prepare a financial analysis of a potential transaction before receiving board approval, participating in the selection of deal counsel, engaging in offer discussions, and making certain public announcements perceived as efforts to garner stockholder support for the acquisition.

Ultimately, however, the court was persuaded by the evidence Musk presented to show that the price paid for SolarCity was fair. Specifically, the court focused on market evidence that supported the price Tesla paid, SolarCity’s current and future cash flows, and the substantial synergies that flowed to Tesla from the transaction. The court found the transaction was therefore “entirely fair” and a verdict was entered for Musk on the breach of fiduciary duty, unjust enrichment and waste claims accordingly.

SEC Announces Expansion of Crypto and Cyber-Security Unit

On May 3, 2022, the U.S. Securities and Exchange Commission (the Commission) announced that it would be significantly bolstering the unit responsible for protecting investors in crypto markets and from cyber-related threats by adding 20 new positions. The unit, newly renamed as the Crypto Assets and Cyber Unit, is tasked with ensuring investors are protected in the crypto markets by investigating and bringing enforcement actions for securities law violations relating to, among other things, crypto asset offerings, exchanges and lending, as well as decentralized finance platforms and non-fungible tokens. The Commission states that the expansion, which brings the unit to 50 dedicated positions in total, will also improve the Commission’s capacity to continue to tackle “the omnipresent cyber-related threats to the nation’s markets.”

Delaware Chancery Court Denies Summary Judgment to Liberty Broadband and Charter Directors on Stockholder Challenge to Merger between Time Warner and Charter

On May 2, 2022, the Delaware Court of Chancery denied summary judgment motions filed by Liberty Broadband Corporation and directors of Charter Communications, Inc., finding there was sufficient evidence in the record to support plaintiff’s allegations that a majority of directors were conflicted when determining the terms of the acquisition of a target entity. The case will now proceed to trial in issues of director independence and entire fairness as to transactions surrounding the merger between Charter and Time Warner Cable, Inc.

The stockholder challenge arose out of three proposed transactions: (1) two Liberty investments into Charter that would allow Liberty to retain a beneficial ownership stake in Charter; (2) a merger between Charter and Time Warner, through which Charter would provide $29.3 billion stock consideration and $27.5 billion cash consideration, and assume approximately $22.6 billion of Time Warner debt; and (3) Charter’s acquisition of Bright House Networks, LLC from Advance/Newhouse Partnership, which would allow Advance/Newhouse to retain a beneficial ownership stake in Charter. The second two transactions were conditioned on the Charter stockholders approving the Liberty investments. The Charter stockholders approved all three transactions in September 2015, and the Time Warner merger and acquisition of Bright House closed on May 18, 2016.

Plaintiffs filed an amended complaint in April 2016, alleging that defendants Liberty; Charter Directors John Malone, Gregory Maffei, Michael Huseby, Balan Nair, Eric Zinterhofer, Craig Jacobson, Thomas Rutledge, David Merritt, Lance Conn, and John Markley; and nominal defendant Charter, breached their fiduciary duties by: (1) approving the stock issuances to Liberty and approving a voting proxy agreement by which Advance/Newhouse would grant Liberty a voting proxy on up to 6% of its shares; and (2) failing to disclose all material facts necessary for shareholders to cast an informed vote on the transactions.

In response, both Charter and Liberty (along with two of Charter’s directors, John Malone and Gregory Maffei), filed motions to dismiss. On May 31, 2017, the court ruled that even though Liberty did not control Charter when the stockholders voted in favor of the acquisition of Bright House and the Time Warner merger, plaintiffs adequately alleged that the stockholder vote was structurally coerced. On July 26, 2018, the court ruled that plaintiffs adequately alleged the Charter directors lacked independence, and that discovery could proceed on plaintiffs’ claim for breach of fiduciary duty. After significant discovery, plaintiffs filed a second amended complaint (SAC) in September 2021, and Liberty and the Charter directors moved for summary judgment thereafter.

In the SAC, plaintiffs alleged that certain directors of Charter — Huseby, Maffei, Malone, Nair, Rutledge, and Zinterhofer — lacked independence at the time of the transactions at issue, and breached their fiduciary duty by approving the Liberty investments. Plaintiffs alleged that Liberty aided and abetted this breach of fiduciary duty. The director defendants conceded that Maffei lacked independence as then-CEO of Liberty Media, which once owned Liberty, and that Malone lacked independence due to his 47% ownership of voting power of Liberty. The SAC also challenged the Liberty investments, arguing that they were not entirely fair due to certain favorable pricing, tax treatment and governance considerations granted to Liberty. In their motions for summary judgment, the defendants argued that a majority of Charter’s directors were independent at the time of the vote upon the Liberty investments, and that the investments should thus be considered under the business judgment rule. The defendants argued in the alternative that even if entire fairness review is appropriate, the record demonstrated a fair process and price for the Liberty investments.

The court considered whether a majority of the Charter board of directors was independent. The court began with the presumption of director independence, but was required to interpret evidence in favor of the party alleging lack of independence to determine whether there was a genuine issue of material fact. The court acknowledged plaintiffs’ concession that directors Maffei and Malone were not independent, which informed its analysis as to the remaining directors.

The court determined that there were genuine issues of material fact, when considering all facts compiled against each director as a whole, as to the independence of several Charter directors. Concerning director Zinterhofer, the court cited his prior experience engaging in joint ventures with Liberty; his role as a director of Liberty Latin America; and his relationship with director Maffei, including the record of his regular agreement with Maffei’s decision-making. For director Husbey, the court cited his professional and personal ties to both Malone and Maffei, including Maffei’s role in referring Huseby for the position of CFO at Barnes & Noble. As to director Nair, the court considered that he was the Executive Vice President and CTO of Liberty Global, had worked in the same building as Malone and Maffei from 2007 to 2016, had publicly praised Malone on various occasions, and had inquired with Maffei as to whether the original Bright House transaction was acceptable. Finally, the court considered that the proposed transactions would result in director in Rutledge’s promotion, increased compensation, and a renewed employment contract as to his primary source of income. The court also pointed to Rutledge’s own assertions that he considered Malone a “significant talker” to whom he listened.

Because the court found that there was sufficient evidence, for the purposes of summary judgment, to show that a majority of the Charter board of directors were not independent, the court determined that the business judgment standard of review was unavailable. The court further found that Liberty had not shown that the transaction was entirely fair as a matter of law. Instead, the court determined that there were genuine issues of material fact to be determined at trial, including whether the Liberty investments were necessary as a prerequisite to the other transactions and the amount of leverage Time Warner would have tolerated in the combined company before accepting a merger offer. The court also left for trial other theories asserted by plaintiffs, including whether the transactions were approved by Charter’s full board of directors, whether fraud on the board occurred in the context of a financial advisor, and whether a set of board resolutions from 2013 conclusively established a lack of independence as to certain directors. The court further denied Liberty’s motion for summary judgment, as the cause of action against Liberty Broadband is for aiding and abetting breach of fiduciary duty and rises and falls with the director defendants’ motion. The plaintiffs’ allegations as to lack of director dependence and lack of entire fairness as to Liberty Broadband investments will proceed to trial.

Delaware Judge Rules that Cryptocurrency Compensation Should be Treated as a Security in Contract Breach Case

On April 14, 2022, in Diamond Fortress Technologies Inc., and Charles Hatcher II v. EverID, Inc., Delaware Superior Court Judge Wallace granted plaintiffs Diamond Fortress Technologies, Inc. and its CEO Charles Hatcher, II’s motion for default judgment, holding that compensation promised in cryptocurrency by defendant EverID, Inc. should be treated as a security for valuation purposes. Using CoinMarketCap as the valuation tool, the court awarded $20,100,000 plus pre- and post-judgment interest to Diamond Fortress and $5,025,000 plus pre- and post-judgment interest to Hatcher.

In September 2018, Diamond Fortress and EverID finalized a license agreement, through which EverID would integrate Diamond Fortress’s proprietary ONYX biometric software into its cryptocurrency platform. Under the agreement, Diamond Fortress would be paid in EverID’s own cryptocurrency, ID Tokens, for EverID’s exclusive use of the ONYX software and would receive 10,000,000 ID Tokens, 25% of which would be distributed upon the Initial Coin Offering (ICO) or final Token Distribution Event (TDE) and 75% in 20 equal quarterly distributions thereafter. EverID also entered into an advisor agreement with Diamond Fortress’s CEO, Charles Hatcher, II, through which it would distribute 2,500,000 ID Tokens to Hatcher with the same distribution structure in exchange for Hatcher’s consulting services as to integration of the ONYX software. Following EverID’s failure to distribute any ID Tokens to Diamond Fortress or Hatcher following its February 8, 2021 ICO or thereafter, plaintiffs filed suit against EverID for breach of contract on May 4, 2021 and, after receiving no response, moved for default judgment on July 16, 2021.

The court determined that EverID had repudiated the contracts and therefore was in total breach of both agreements, but invited additional briefing as to the computation of damages. The court, noting that the issue of calculating damages for consideration denominated in cryptocurrency was “novel,” explained that the lack of regulatory authority regarding cryptocurrency has led to a lack of consensus on whether cryptocurrency should be treated as a security, commodity, property, or currency, but acknowledged that the SEC had determined that cryptocurrencies are securities subject to the Securities Act of 1933 and the Securities Exchange Act of 1934. The court also pointed to proposed Congressional legislation, the Digital Asset Market Structure and Investor Protection Act, for the proposition that a cryptocurrency’s characteristics at a given time best determine whether it is subject to securities regulation.

Next, the court turned to application of the three-part test articulated in S.E.C. v. W.J. Howey Co., 328 U.S. 293 (1946), which is routinely used to determine whether a digital asset is an investment contract, and therefore subject to the securities laws: (1) whether an investment of money was part of the relevant transaction; (2) whether a common enterprise exists where the investor’s success is dependent upon the efforts and success of those seeking the investment of third parties; and (3) whether the investor entered into a transaction with the expectation of profits based upon the efforts of others.

Applying the Howey factors, the court held that the ID Token cryptocurrency was a security. First, the court held that the plaintiffs had made an “investment of money” under Howey by granting EverID an exclusive license to their ONYX software, and provided EverID with related professional services, while in turn electing to be paid in eventual ID Token distributions, knowing that the value of the ID Tokens would fluctuate over time. Second, the court found that plaintiff engaged in a common enterprise because plaintiffs’ ability to earn ID Tokens depended on the successful launch of EverID’s product using the plaintiffs’ technology. Third, the court found that the plaintiffs had entered into the transaction with an “expectation of profits” because they granted EverID the exclusive ONYX license with the reasonable belief that the plaintiffs would make a profit as result of EverID’s success, despite the risks involved. The court also considered that the parties’ license agreements made clear that ID Token distributions were subject to regulatory compliance under Rule 144 of the Securities Act of 1933, finding that this demonstrated that the parties intended to treat the ID Tokens issued at each distribution as a security.

Once finding that the ID token is a security, the court turned to the proper method for determining damages, accounting for the terms of the parties’ agreements as well as the inherent volatility of cryptocurrency. The court applied the “New York rule,” followed in Delaware, which measures damages by the higher of either the stock’s value at the time of conversion, or the highest intermediate value between notice of the conversion and a reasonable time thereafter during which the stock could have been replaced. The court relied upon the posted values on CoinMarketCap, finding that it was a “reliable cryptocurrency valuation tool” based upon available precedent. The court determined that each ID Token was worth $2.01, which represented the highest cash value of the ID Tokens between the date of plaintiffs’ final communications to the defendant regarding the breach and three months thereafter. That cash value of $2.01 per token was multiplied by the total number of ID Tokens promised in each plaintiff’s contract to calculate the damage awards of $20,100,000 to Diamond Fortress and $5,025,000 to CEO Charles Hatcher, II. The court also awarded pre-judgement at the statutory rate accruing from March 4, 2021, the day the plaintiffs were “absolutely entitled to the token distributions” and post-judgment interest, accruing from the date of the Opinion and Order.

Twitter Stockholder Files Suit to Delay Musk Takeover

On May 6, 2022, a stockholder of Twitter filed a putative class action complaint in the Delaware Court of Chancery seeking to prevent Elon Musk’s $44 billion acquisition of the company from closing on its current timeline. The complaint, filed by Orlando Police Pension Fund, seeks a declaratory judgment that Musk is an “interested stockholder” under Delaware law, which will govern the conditions under which the transaction can go forward.

The complaint is brought under Section 203 of the Delaware General Corporation Law, which prevents a shareholder and its affiliates from engaging in a tender or exchange offer for a period of three years after buying more than 15% of the company’s stock unless certain criteria are met, including that the transaction is approved by an affirmative vote of at least 662/3% of the outstanding voting stock not owned by said shareholder.

Musk began acquiring Twitter shares in January 2022 and personally owned approximately 9.6% of Twitter’s outstanding voting stock when the Board approved the proposed takeover. Notwithstanding the fact that Musk’s personal holdings were below the threshold, the complaint alleges that Musk’s arrangements and understandings with two other significant beneficial owners of Twitter’s outstanding voting stock — Morgan Stanley and Twitter co-founder, former CEO, and director Jack Dorsey — render Musk an “interested shareholder” within the meaning Section 203. The complaint alleges that Morgan Stanley has served as Musk’s long-time financial advisor, and is alleged to have played a significant role in financing Musk’s bid for Twitter in exchange for substantial investment banking fees. The complaint also alleges that Dorsey “instigated Musk’s pursuit” of the takeover and has supported Musk publicly in manner sufficient to suggest the two have an “understanding” that Dorsey will “support Musk’s takeover bid and vote his shares in Musk’s favor.” The complaint claims that, taken collectively with Morgan Stanley and Dorsey’s ownership, Musk is an “interested stockholder” within the meaning of Section 203, and is therefore subject to its statutory protections.

Plaintiff seeks a “prompt trial” on its claims to “ensure the vote of Twitter stockholders on the Proposed Takeover” — the date for which has not yet been set — is “properly informed.” Musk has since announced that the proposed transaction is “on hold” pending further investigation about spam and fake user accounts. 

Lawyers in Goodwin’s Securities and Shareholder Litigation and White Collar Defense practices have extensive experience before U.S. federal and state courts, legislative bodies and regulatory and enforcement agencies. We continually monitor notable developments in these venues to prepare the Securities Snapshot — a bi-weekly compilation of securities litigation news delivered to subscribers via email. This publication summarizes news from the civil and criminal securities law arenas in a succinct, digestible format. Topics covered include litigation and enforcement matters, legislation, rulemaking, and interpretive guidance from regulatory agencies.

Editorial Board
Meghan K. Spillane

Contributing Authors
Virginia Calistro
Ilana Saltz
Viktors Dindzans
Catherine Tremble