Elon Musk’s Threat

In the wake of a judicial decision invalidating Tesla CEO Elon Musk’s stock-option package, Tesla’s shareholders have voted overwhelmingly to ratify Musk’s pay. Rather than respect investors’ judgment, however, the lawyers who brought the case claimed that the shareholder vote was coerced by Musk’s alleged “threat” to develop AI technology outside Tesla if he didn’t get his shares. This claim confuses a threat with a negotiation. Musk was and is entitled to take his ideas elsewhere, which is why Tesla gave him stock options in the first place.

In January, a Delaware court found that the Tesla board breached its fiduciary duties by granting Musk options to buy millions of Tesla shares – options that 73 percent of investors voted to approve in 2018 and that vested only if Musk made Tesla 12 times more valuable. Musk kept his side of that bargain, but the court ruled that the approval process was flawed. The court found that Musk was a controlling owner, thus subjecting the approval to the heightened requirements that the transaction be approved by both a special committee of independent disinterested directors and the majority of minority shareholders. The court also found that some of the directors on the special committee were not independent and that the shareholders were not informed about the flaws of the special committee. Consequently, the court invalidated the original 2018 shareholder vote and placed the burden on Musk to prove that the compensation was fair. Musk did not meet this burden, leading to the invalidation of his compensation package. So Tesla went back to investors, attaching the court’s opinion and disclosing directors’ identified conflicts of interest – and this time 72 percent of investors voted to approve. One might think that would be the end of the matter.

But on Friday, June 21, the lawyers who brought the case – with their $5.9 billion fee request hanging in the balance – wrote to the judge that those investors had been forced to vote yes. The reason, they said, is that months ago Musk “threatened” to develop artificial-intelligence projects “outside Tesla” if he did not have more voting power at the company. But students of economics know the difference between bargaining tactics and threats. All Musk did was negotiate with investors who want to pay for his work.

To see why, consider two types of contracts for labor. In a complete contract, like a contract to build a house, the employee’s work, such as the quality of materials used and adherence to design specifications, is observable and verifiable, so commitments can be enforced in court. But in an incomplete contract, like joint ventures between entrepreneurs and investors, the employees’ task – to build a transformative enterprise without knowing exactly how or when – can’t be contracted for because they can’t be easily observed or verified. Obviously, courts can’t force an entrepreneur to innovate. Instead, the parties bargain for incentives that reward the entrepreneur for devoting time and ideas to the company’s success. The market for the company’s value, rather than a court, measures the CEO’s effort – and accordingly either rewards or dismisses him.

After the court invalidated his stock options, Musk’s message to investors was clear: His incentives were no longer aligned with those of Tesla shareholders. Without those incentives, Musk told shareholders they should not expect high-value performance. That’s not a threat. That’s a typical negotiation over pay for performance.

If shareholders disliked Musk’s terms, they were free to reject them, with two likely outcomes: Either Musk would leave or Musk would stay but would not perform and would have to be fired. Either way, Tesla would have to find another CEO. Instead, investors concluded – twice – that Musk is too crucial to Tesla’s future success to risk that he will take his talents elsewhere. True, this means that Musk has considerable bargaining power. But we don’t call using one’s bargaining power a “threat.” When a seller tells a buyer that, if the right price is not offered, the item will be sold to someone else, we don’t say the buyer was threatened. Statements like these reflect bargaining, not bullying.

What’s more, the coercion argument attempts to make victims out of large, sophisticated financial players. Major institutional investors like BlackRock and Vanguard voted in support of Musk, and to suggest that he could coerce them into doing so is far-fetched. Many other large shareholders – from Amalgamated Bank to the Norwegian Sovereign Wealth Fund to the New York City Comptroller – voted no. This isn’t a split among institutions that were afraid of Musk’s “threat,” so voted yes, and those who were unafraid, so voted no. Instead, the division is between those who think Tesla needs Musk, and thus need to give him proper incentives, and those who think Tesla can do without him now that Tesla is a mature company. Both positions are grounded in business considerations, not fear or courage.

Accepting the ratification vote means that the court will reverse its original ruling, with one of two possible results. The first possible result is that the ratification vote will provide the stock-option plan the business judgment rule protection. For this result, the court needs to determine that Musk is no longer a controlling owner, given that today he only owns 13 percent of Tesla’s shares and that he did not interfere with the ratification process. The second possible result is that the court will consider Musk’s original controlling owner status as continuing for the ratification process, thus keeping the applicability of the entire fairness test. In this case, the burden will shift to the plaintiff to prove that the compensation was unfair. Given the shareholder ratification, the plaintiff is unlikely to meet this burden, and the compensation package will likely be approved.

Tesla’s shareholders have spoken. The argument that CEOs who drive hard bargains make investors mere victims should have no place in American business law. It’s shareholder money that will be used to pay Musk, and they are in the best position to know what bargains are best for Tesla’s future. The Delaware court should accept the shareholders’ vote, as failure to do so will shift the public perception from a case of Delaware versus Musk to one of Delaware versus the shareholders.

This post comes to us from Zohar Goshen, the Jerome L. Greene Professor of Transactional Law at Columbia Law School.

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