March 29, 2018 / 8:08 PM / a year ago

Elon Musk runs Tesla – and that means shareholders can sue

(Reuters) - Everyone knows Tesla is run by Elon Musk, the visionary CEO who is synonymous with his company. Tesla has acknowledged as much in public filings that described the company as “highly dependent on the services of Elon Musk.” Musk himself called Tesla “my company” in a 2016 conference call with analysts, and he’s claimed publicly that if he had not taken on the CEO job, the company would not have survived. Tesla’s board is stacked with Musk allies, including his brother and two close friends and investors whom Musk bestowed with prototype Tesla cars.

Given Musk’s towering persona, it might surprise you to know that he actually owns only about 22 percent of Tesla’s shares. So does Musk, as a legal matter, control Tesla?

That was the question before Vice-Chancellor Joseph Slights of Delaware Chancery Court in consolidated shareholder and derivative litigation over Tesla’s $2 billion acquisition of SolarCity – another Musk company – in 2016. As you know, the standard of scrutiny is more exacting in deals involving companies controlled by majority shareholders than in companies with no controlling investor. Corporations without a majority shareholder are almost always entitled to business judgment deference, which is pretty much a death knell for shareholder suits. Even if investors can show the sale process was flawed, the Delaware Supreme Court said in 2016’s Corwin v. KKR Financial Holdings, corporate boards are still shielded by the business judgment rule as long as the transaction was approved by a majority of shareholders.

Corwin comes with a catch, though: It applies just to companies without a controlling shareholder.

No problem, said lawyers for Tesla and its board members. Wachtell Lipton Rosen & Katz argued in a motion to dismiss the consolidated shareholder suit that Musk’s 22 percent ownership of Tesla is too small to be considered a controlling stake. The Delaware Supreme Court’s most aggressive precedent on control by a minority shareholder was 2003’s In re Cysive, in which the court said a shareholder with a 40 percent stake wielded enough voting power to be considered a controlling shareholder, according to the Wachtell motion. Musk holds a considerably smaller stake in Tesla, the motion said, and independent institutional investors control their own big chunks of Tesla stock.

Tesla said Musk’s dominant managerial style doesn’t make him a majority owner. “CEOs (especially good ones) often exercise significant day-to-day control over a company’s operations; they often have significant stockholdings; and they are often the public face of their companies,” the Tesla brief said. “That’s their job. Such facts do not make them controlling stockholders under Delaware law.” Tesla stock holders, Wachtell argued, voted in favor of SolarCity acquisition. (Musk and other Tesla shareholders with overlapping stakes in SolarCity did not vote.) Under Corwin, Wachtell said, the vote entitles the Tesla board to business judgment deference.

Shareholders, represented by lead counsel from Robbins Geller Rudman & Dowd, Grant & Eisenhofer and Kessler Topaz Meltzer & Check, said Tesla’s argument defied the reality of Musk’s power and influence at the company and underestimated the conflicts of Tesla board members who also held stakes in SolarCity, and thus stood to benefit when Tesla acquired the near-worthless company.

“Musk … controls Tesla through a combination of his voting power as the company’s largest stockholder and his managerial authority derived from his status as the company’s visionary, inspirational force, CEO and chairman, and from his active and crucial role in the day-to-day operations and technical advancements of Tesla,” shareholders argued in their brief opposing dismissal. “Musk’s power to control the Tesla Board was particularly potent in the (SolarCity) acquisition because at least a majority of its members shared a special interest in the acquisition with him or were under his influence.”

Vice-Chancellor Slights sided with the shareholders, finding that Musk effectively controlled the board’s decision to acquire SolarCity even though he owned only 22 percent of Tesla’s shares. The judge said at the beginning of his opinion that the case was “a close call,” but the body of his decision offers an array of justifications for his holding.

Slights seemed particularly skeptical about the deal process, in which Musk asked the board three times to buy an ever-more precarious SolarCity. Tesla’s other directors never formed an independent committee to evaluate the deal and never considered the purchase of a different solar power company instead of SolarCity, despite what the vice-chancellor called “the Tesla board members’ obvious conflicts.” The board’s first meeting with Tesla’s financial advisor on the SolarCity deal, Evercore, was the session in which it agreed to the acquisition. Musk and another conflicted Tesla director recused themselves from that meeting – but both actually were present for the board presentation on the SolarCity deal. Musk, according to Vice-Chancellor Slights, “led most of those discussions.”

Shareholders plausibly alleged that Tesla took “practically no steps … to separate Musk from the board’s consideration of the acquisition,” Slights wrote. “When Musk rather insistently brought the proposed acquisition to the board for consideration, the board was well aware of Musk’s singularly important role in sustaining Tesla in hard times and providing the vision for the company’s success.”

Numerically, Musk’s 22 percent stake wasn’t dispositive, the judge said, but the board surely knew of his “willingness to facilitate the ouster of senior management when displeased.” And the Tesla bylaws, he said, impose supermajority voting requirements on a variety of important corporate decisions, giving Musk, as the largest shareholder, “significant control over corporate matters while only owning approximately 22% of Tesla’s common stock.”

The combination of Musk’s voting influence, indispensability to Tesla and domination of the deal process added up to the same level of control a majority shareholder would hold, Vice-Chancellor Slights said. Therefore, he ruled, the Tesla shareholder vote doesn’t entitle the board to business judgment review under Corwin. Shareholders can now move ahead with discovery on their breach-of-duty and other claims.

The Tesla ruling is a rare win for investors litigating in Delaware Chancery Court, and I suspect few acquisitions fit the fact pattern Vice-Chancellor Slights described in the Tesla opinion. But it’s good to know that even in the Corwin era, shareholders can still have a shot at holding corporate directors accountable.

I emailed William Savitt of Wachtell, who argued for Tesla board members at the Dec. 17 hearing on the company’s motion to dismiss, but didn’t hear back.

The views expressed in this article are not those of Reuters News.

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