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From Securities Regulation Daily, March 29, 2018

Tesla’s Elon Musk is controlling shareholder at pleading stage of shareholder suit

By Mark S. Nelson, J.D.

The Delaware Chancery Court determined that it was “reasonably conceivable” that Tesla, Inc.’s CEO and chairman, Elon Musk, was a controlling shareholder of the company for purposes of a motion to dismiss a shareholder complaint alleging improprieties over a deal in which Tesla acquired SolarCity Corporation. Tesla’s shareholders had pointed to Musk’s brusque management style and persistent efforts to complete the deal, to numerous interlocking directorships between Tesla and SolarCity, and to other alleged conflicts of interest among Tesla’s directors. In reaching his conclusion, the vice chancellor said entire fairness review applied and he declined to apply the Corwin cleansing test despite Tesla’s urgings (In Re: Tesla Motors, Inc. Stockholder Litigation, March 28, 2018, Slights, J.).

Tesla’s "Master plan, Part Deux" drives deal. The Tesla shareholders’ class action derivative suit alleged that the Tesla-SolarCity deal was a thinly disguised financial rescue undertaken on behalf of most of Tesla’s board and for those board members’ families and business partners. Due diligence had unearthed worries about SolarCity’s liquidity woes and its lack of access to debt and equity markets. The complaint highlighted just how bad the SolarCity deal appeared to be by noting that, at the time Musk was pressing Tesla’s board to approve an offer for SolarCity, Goldman Sachs & Co., the co-underwriter of a recent Tesla secondary stock offering, told the investing public that SolarCity was among the "worst positioned" (internal quotation omitted) companies to fuel growth in the solar sector.

Musk, arguing in support of an offer for SolarCity, referred to Tesla’s long-term strategy contained in its "Master Plan, Part Deux," which called for Tesla initially to sell pricey electric cars while persistently moving to a higher volume, more affordable electric car. This shift to a high production business model would be enhanced by the addition of more diversified solar assets, an enhancement that Musk suggested could not be achieved without the acquisition of SolarCity.

At the heart of the shareholders’ case, however, is the interconnectedness between Musk and other Tesla board members and SolarCity. Musk himself is both chairman and CEO of Tesla and serves as chairman of SolarCity. Musk’s brother, Kimbal Musk, is a Tesla director. Musk and his cousins Peter and Lyndon Rive founded SolarCity. Moreover, three of seven Tesla directors invested in Tesla and/or SolarCity via their venture capital firms (including a SolarCity director who once was an observer on Tesla’s board); one director’s online map company received millions in fees from Tesla; two directors were declared not to be independent in proxies and other SEC filings; Musk gave Tesla cars representing Tesla milestones to at least one director; and Musk invested in funds run by some of Tesla’s directors. Musk is the largest shareholder of Tesla and SolarCity with 22.1 and 21.9 percent of these company’s shares, respectively.

Significantly, Musk and two other directors, including Tesla’s lead independent director, were excluded from the shareholder vote on the SolarCity acquisition (the vice chancellor noted that Tesla did not have to put the deal to a shareholder vote). But Tesla’s four other directors along with Tesla executives and other Tesla shareholders who also owned SolarCity shares were allowed to vote. According to numbers cited by the complaint, 58.27 percent of Tesla’s shareholders approved the deal (118,044,090 outstanding shares, minus shares of excluded shareholders, with 68,788,787 voting to approve). When the acquisition was announced, the exchange ratio was set at 0.110 shares (it was an all-stock deal), which was somewhat below the earlier predicted range, such that SolarCity was valued at $25.37 per share or $2.6 billion. The deal closed in November 2016.

Musk a controller at pleading stage. Tesla urged the vice chancellor to apply the Delaware Supreme Court’s Corwin cleanse to the Tesla shareholder vote on the acquisition of SolarCity. In Corwin, the state’s justices said the deferential business judgment rule, rather than entire fairness review, applies where a deal was approved by a company’s fully informed, uncoerced majority of disinterested shareholders. But Tesla’s shareholders said Corwin was inapt because Musk acted as a controlling shareholder.

Although the vice chancellor acknowledged that controller issues can prove befuddling at the pleading stage of a case, the Tesla shareholders had to do no more than allege it was reasonably conceivable Musk was a controller. The court then looked to the Delaware Supreme Court’s Kahn decision to determine if Musk exercised the degree of control that might call into question the propriety of the Tesla shareholder vote on SolarCity.

Under Kahn, a person is a controlling shareholder if they either own more than 50 percent of a company’s voting stock, or if they own a smaller percentage than that and still exercise control over the company’s affairs. The vice chancellor noted that other court decisions add gloss to the notion of when a shareholder controls a company’s affairs, such that a court could mull whether the shareholder exercised "actual domination and control" over other directors and whether independent directors were unfree to exercise their judgment. Moreover, control can be of a general type, or it may relate only to a specific transaction.

While Tesla argued that Musk’s 22.1 percent share is too small to result in control, the court found more persuasive the shareholders’ theory that Musk’s prior ouster of Tesla’s CEO (after which Musk made himself CEO) coupled with Tesla’s bylaw supermajority voting provisions could enable Musk to exercise control over Tesla (the court also noted that the theory that Musk’s vision for Tesla was the attractive force for public investments in Tesla, by itself, would not necessarily indicate Musk’s control).

The vice chancellor also addressed the related "face of Tesla" argument regarding Musk, which the court said could not support controller status by itself (seeDell (Chancery Court opinion) and Rouse for examples of non-controllers). Rather, the court noted the complaint’s recitations about how Musk was the driving force of the SolarCity acquisition to the exclusion of other alternatives, a theory that could support the conclusion that Musk acted in a controlling manner towards Tesla’s board. Tesla’s board also did not create a special committee for the SolarCity deal despite many potential conflicts. In a footnote, the court "acknowledge[d]" Tesla’s concern that Musk could be deemed a controller because of his aggressive management style. The vice chancellor ended that footnote by saying: "…there is much more to this Complaint’s pleading of control than conclusory allegations that Musk is an effective and dynamic CEO."

Lastly, the court observed that the shareholders alleged many board-level conflicts and that Musk’s behavior suggested a controlling influence. On this last point, the court noted that Tesla and Musk had not conceded that Musk is a controller, as did happen in another case (seeZhongpin ). The court was reluctant to accept public statements of Musk’s alleged control, such as that Musk is the apex of a "pyramid" whose base consists of Tesla, SolarCity, and SpaceX, Musk’s aerospace company known for its reusable rockets that have visited the International Space Station.

Overall, the court found that, for purposes of a motion to dismiss, the shareholders had raised a reasonable inference that Musk was a controlling shareholder of Tesla. But the court declined to address whether the shareholders had alleged a non-exculpated claim of breach of fiduciary duty because, at least for now, Tesla had waived the question of whether the exculpatory provision in its certificate of incorporation would exonerate any of its directors, although the court said Tesla can raise the question later.

The case is No. 12711-VCS.

Attorneys: Jay W. Eisenhofer (Grant & Eisenhofer P.A) for Tesla shareholders. David E. Ross (Ross Aronstam & Moritz LLP) and William Savitt (Wachtell, Lipton, Rosen & Katz) for Tesla, Inc., Elon Musk, Brad W. Buss, Robyn M. Denholm, Ira Ehrenpreis, Antonio J. Gracias, Stephen T. Jurvetson, and Kimbal Musk.

Companies: Tesla, Inc.; SolarCity Corporation

MainStory: TopStory CorporateFinance CorporateGovernance CorpGovNews GCNNews DirectorsOfficers FiduciaryDuties MergersAcquisitions DelawareNews

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