Tesla's Common Law Ratification Argument: You'll Need Crazy Pills to Understand It

In Part 2 of 3, we examine the Tornetta defendants' arguments for common law ratification, and ask whether Plaintiff can kill those arguments before they grow into fact-intensive controversies.

In Part 1 of this series, I took a deep dive into the statutory ratification issue in Tornetta v. Musk¹ and concluded that statutory ratification is likely a losing argument for Defendants.

Today, in this Part 2, I and my collaborator (a Silicon Valley corporate attorney who has served on the board of several well-known tech companies) examine the more complex issue of common law ratification, which is where Defendants focused most of their briefing. (Part 3, yet to come, will discuss the intriguing issue of corporate waste.)

(Microsoft Designer AI imagines lawyers taking crazy pills.)

I. The Name of the Game: Kill Shots

As a reminder, Defendants’ arguments are built on a preposterous narrative of invented facts, including these:

• “Musk did not control Tesla or the ratification itself.”

• Kathleen Wilson-Thompson, the sole member of the Special Committee of One, which “committee” recommended the ratification vote, is “an indisputably independent director.”

• The shareholders were “fully-informed,” and had “full knowledge of the facts.”

• The shareholder vote was “uncoerced.”

The problem for Plaintiff is that dismantling this foundation of lies would require reopening the trial record to gather more documents and take more depositions. And that, of course, would require at least several more months of work in a case that is now more than six years old.

In order to avoid such further delay, Plaintiff needs arguments that support its view that the ratification vote was ineffective to undo the Court’s January 30, 2024 ruling (the Rescission Ruling) rescinding the 2018 grant to Musk of a stock options compensation package (the 2018 Grant). Plaintiff needs, in short, some kill shots that are purely legal and require no further evidence, or that require additional evidence on only one or two narrow issues of limited scope.

I’ve already concluded that Plaintiff likely has such kill shots on the statutory ratification issue. So, now let’s examine whether Plaintiff can efficiently dispose of Defendants’ arguments that the June 13 shareholder vote was legally effective to ratify the 2018 Grant based on Delaware’s doctrine of common law ratification.

II. Defendants’ Decidedly Daft Arguments

The arguments by both nominal Defendant Tesla and the individual Director Defendants about common law ratification are serpentine, confusing, and outrageous. I despair of doing justice here to all of the inherent craziness of the arguments’ looping convolutions.

For starters, Defendants are asserting, simultaneously, that they are merely ratifying an old transaction (which was burdened with the fatal defects of a controlling shareholder and a beholden special committee) and yet are doing so with a ratification vote that is a brand new transaction, supposedly free of such defects.

Then there are the numerous slapdash and reckless case citations in which Defendants claim that a particular precedent stands for a certain proposition, when a careful reading of the case belies that claim.

And, most amazingly brazen of all, Defendants’ entire argument rests on the claim that Elon Musk is not, in fact, in control of Tesla.

Crazy stuff indeed. But, again, the question is: Does Plaintiff have one or more “kill shots” sufficient to extinguish the common law ratification argument without reopening the trial record?

Here are what I regard as among Plaintiff’s most promising possibilities.²

A. Musk Can’t Put the Toothpaste Back in the Tube

Can a party to a lawsuit go to trial, suffer a total defeat, and then seek a do-over on a newly-created trial record? That is what Musk & Co. are seeking here, both with the common law ratification and statutory ratification claims.

Professor Elson, in his amicus brief, is emphatic that to allow such a ploy would create a “serious moral hazard” because it would encourage the filing of materially misleading proxy statements by corporate boards that know they will be allowed a “mulligan” if they are challenged.

Rather than address Elson’s policy argument, the individual Defendants respond by claiming that the Delaware Supreme Court has already allowed a similar mulligan. They cite the 1952 case called Kerbs v. California Eastern Airways, asserting that “a post-trial ratification was first raised on appeal warranting a remand to adjudicate whether ‘validity of the adoption of the plan by the directors has now become moot by reason of stockholders’ ratification’.” (emphasis by Defendants; interior quote from Kerbs)

The problem for Defendants is that the Chancellor in Kerbs had upheld rather than voided the profit-sharing plan at issue. In other words, there was no attempt to undo via shareholder ratification an earlier ruling by the Chancellor. Rather, it appears that the attempt was to fortify the earlier ruling. Defendants, conveniently, fail to note that seemingly vital distinction.

Also worth nothing is that in Krebs, there was no controlling shareholder issue, and hence no need to wrestle with the stringent requirements of two important Delaware Supreme Court cases: Kahn v. MF Worldwide Corp. (often referred to as MFW) and In re Match Group, Inc. Derivative Litigation. Here, of course, the Court’s Rescission Ruling is founded on a finding that Musk was a controlling shareholder.

Given Musk’s status as a controlling shareholder who was on both sides of the transaction, MFW and Match Group require Tesla to show, among other things, that (1) the process followed by the Tesla Board was proper, and (2) the compensation package was approved by a properly functioning independent committee. (I discuss MFW and Match Group in more detail below.)

Defendants also rely on a 1979 Delaware Supreme Court case called Michelson v. Duncan. Michelson is similar to Tornetta in that it involved a challenge to the issuance of stock options. However, Michelson is quite different in several key respects. For one thing, the Michelson plaintiff made no claim of a breach of fiduciary duty; rather, the claim was that the directors amending the stock option plan lacked authority to do so without shareholder approval. Moreover, in Michelson, the proxy statement was issued and the shareholder ratification vote took place before the Court of Chancery had made any ruling.

Chancellor McCormick could always hold otherwise, but it appears to me that Defendants have failed to offer her either (1) any policy reason to overcome Professor Elson’s concern about the “moral hazard” ratification would create, or (2) any legal authority for the proposition that an after-the-fact shareholder vote can undo an earlier ruling.

B. The Limits of Agency Law

Implicit in Defendants’ argument is that Delaware common law ratification can extinguish a breach of fiduciary claim. While Defendants’ briefing does not expressly make that claim, it appears in Tesla’s proxy statement:

Common law ratification can also extinguish claims for breach of fiduciary duty by authorizing an act that otherwise would constitute a breach. When properly implemented, common law ratification “reaches back” to validate the challenged act as of its initial enactment. The Company believes that, under the Tornetta Opinion, the 2018 CEO Performance Award is such an act that may be ratified under Delaware common law.

This statement is “flatly incorrect,” argues Professor Elson in his amicus brief. Ratification derives from agency law, and is concerned with the after-the-fact conferring of legal authority on an agent who has acted without authority. Citing several Delaware cases, Elson contends that Delaware has only selectively adopted agency principles in the corporate context.

In particular, Professor Elson quotes from a 2009 Delaware Supreme Court case called Gantler v. Stephens: “The only species of claim that shareholder ratification can validly extinguish is a claim that the directors lacked the authority to take action that was later ratified.”

The briefs of both the individual Defendants and nominal Defendant Tesla cite Gantler. Indeed, they quote language from Gantler:

[W]here a fully informed shareholder vote approves director action that does not legally require shareholder approval in order to become legally effective . . . the ‘cleansing’ effect of such a ratifying shareholder vote is to subject the challenged director action to business judgment review.

However, Defendants make two rather telling omissions. First, they omit the sentence’s first three words: “With one exception,”. Second, they omit the sentence’s footnote, which contains exactly the language quoted by Professor Elson.

Defendants also cite a 2000 Court of Chancery decision, State of Wisconsin Investment Board v. Peerless System Corporation, for the “power of ratification to moot stockholder litigation.” In Peerless, though, the claimed ratification occurred before the litigation arose, not after it. Moreover, the Peerless decision seems actually to support Plaintiff, as (like Gantler) it distinguishes between “void” and “voidable” acts (footnotes omitted):

Delaware law divides improper acts by the board into two separate categories, void acts and voidable acts. Void acts include those that are ultra vires, fraudulent, gifts or waste, and are legal nullities incapable of cure. Voidable acts are performed in the interest of the company, but beyond the authority of management, and are also cause for relief. If the shareholders ratify the voidable act after the fact, as opposed to the void act, the ratification cures the defect and relates back to moot all claims provided that the ratification was “fairly accomplished.”

The breach of fiduciary duty committed by Tesla’s directors in making the 2018 Grant would seem to fall into the void category, and hence not subject to ratification.

Here, again, while Chancellor McCormick could hold differently, it appears Plaintiff has a potentially dispositive legal argument to dispose of Defendants’ common law ratification claim.

C. The $265 Million Wilson-Thompson Problem

Defendants’ briefs endlessly recite that Kathleen Wilson-Thompson, the sole member of the “Special Committee” that recommended both the ratification of the 2018 Grant and Tesla’s reincorporation in Texas, is “independent.” Indeed, Defendants claim she is “indisputably independent.”

Forgive my impertinence, but I most assuredly do dispute that claim. As argued here, here, and here, there is powerful evidence to establish that Wilson-Thompson is not independent, but is instead beholden to Musk. The question for our purposes is whether her lack of independence can be established without reopening the trial record.

1. Wilson-Thompson = Denholm

Tesla’s April 17 preliminary proxy statement is part of the existing trial record. As it discloses, Wilson-Thompson, by reason of her six years on the Tesla board, has been the beneficiary of immense grants of Tesla stock and/or stock options. The proxy reveals that she has already realized $62 million from sales of Tesla shares and that she owns an additional 771,255 shares (which, as I write this, equates to a value of $203 million). Add it up and Wilson-Thompson has received $265 million for six years of service on Tesla’s board (though that number will fluctuate as Tesla’s share price fluctuates).

By contrast, the average compensation last year for the director of a U.S. public company was a record high of $321,000 (and one wonders how much lower that figure would be if the Tesla directors were excluded from the calculation). In other words, Wilson-Thompson has received director compensation that is well north of 100 times the average.³

The proxy states that Wilson-Thompson’s Tesla holdings are “a meaningful portion of her net worth.” So, how meaningful is “meaningful”? More precisely, how does the magnitude of Wilson-Thompson’s Tesla-derived wealth compare to her non-Tesla compensation and wealth?

Tellingly, the proxy omits that comparison information. Does anyone doubt that if Wilson-Thompson’s Tesla-derived wealth did not dwarf her non-Tesla compensation and wealth, Tesla would have detailed that fact in the proxy statement?

The omission is particularly glaring given Chancellor McCormick’s determination that Robyn Denholm was not independent precisely because Denholm’s Tesla-derived wealth was, by her own admission, “life-changing,” and far exceeded her compensation from other sources. While the Chancellor has not (yet) found that Wilson-Thompson is beholden to Musk in the same manner as Denholm, given the $260 million plus of wealth Wilson-Thompson has obtained from Tesla, the exact same reasoning applies to her that the Chancellor applied in evaluating Denholm.

2. Sorry to Deny Your Request, Kathleen, But Elon’s in a Big Hurry

Even if Tesla could somehow overcome the obvious presumption that Wilson-Thompson is controlled (just like Denholm was controlled) because of her massive compensation by Tesla and Musk, other facts disclosed in the proxy are powerful evidence of control.

The proxy discloses that the board picked two directors to be special committee members to evaluate the reincorporation proposal. One of them (Wilson-Thompson) had been enormously compensated and was thus heavily in debt to Musk, while the other (Joe Gebbia) had not yet been so compensated.     

And then the director who had NOT been so vastly compensated promptly resigned once he was informed that it was not merely reincorporation in Texas that was being demanded, but also “ratification” of the 2018 Grant. By his action, he said, in effect, “I am not comfortable rubber stamping this prior action.”  

At that point, Wilson-Thompson, the only remaining director on the Special Committee, seeking to cure what she obviously felt was a crippling lack of independence, asked “the Chair of the Board” (Denholm), “the Chair of the Nominating and Corporate Governance Committee” (Ira Ehrenpreis), and “management”⁴ to appoint more independent directors. But the controlled board DENIED this request. The proxy offers only this deliberately cryptic explanation for why the request was denied: “The Special Committee reported that the timing of the ongoing director search ultimately did not fit with the Special Committee’s work”

There can be no greater evidence of Musk’s control over Denholm and Ehrenpreis than that they had the ability to force, and then in fact did force, the one director whom they claim was independent to accept their instruction to proceed without taking further curative steps, steps that she herself requested. And there can be no greater evidence of Musk’s control over Wilson-Thompson than that she meekly accepted the instruction.

(It would be interesting to know whether Wilson-Thompson’s request was made after the Special Committee engaged its legal counsel and, indeed, whether the source of the suggestion was that legal counsel.)

Given what is stated in, and omitted from, the proxy statement regarding Wilson-Thompson’s compensation and her vain request for the addition of independent directors to the board, the trial record may well already contain sufficient evidence to establish that, as a matter of law, Wilson-Thompson is not independent. If the Court has any hesitation on that point, one can imagine Plaintiff asking the Court to re-open discovery solely to determine the magnitude of Wilson-Thompson’s compensation and wealth not derived from Tesla.

3. She Did Everything (Except What Needed Doing)

Besides having received riches that compromise her independence, Wilson-Thompson poses other legal problems for Defendants. The proxy statement admits that she made no substantive effort to evaluate the 2018 Grant itself:

Because of the nature of the ratification process, the Special Committee did not substantively re-evaluate the amount or terms of the 2018 CEO Performance Award and did not engage a compensation consultant. It did not negotiate with Mr. Musk. The Special Committee determined that none of those steps would have been consistent with ratification. The Special Committee noted that the Board previously decided in January 2018 that the 2018 CEO Performance Award was fair, and noted that Ms. Wilson-Thompson was not on the Board at that time. The Special Committee further noted that the defendants in Tornetta will be appealing the ruling because they believe the compensation plan is fair and should be upheld as agreed. The Special Committee assessed only whether the 2018 CEO Performance Award, as it was previously agreed to, should be ratified by stockholders at this time based on the facts that currently exist.

Contrast this statement of what Wilson-Thompson declined to do with what Delaware law requires an independent special committee to do when faced with the decision of how to compensate a controlling shareholder: hire a compensation consultant or financial advisors to assist with the vital task of evaluating the fairness of the compensation package, and then negotiate at arm’s length with that controlling shareholder.

The failure to evaluate the 2018 Grant is especially stunning given the Chancellor’s finding that not a single Tesla director ever asked this crucial question (footnotes omitted):

Why did Tesla have to “give” anything in these circumstances? Musk owned 21.9% of Tesla at the time of the Grant. If the goals were retention, engagement, and alignment, then Musk’s pre-existing equity stake provided a powerful incentive for Musk to stay and grow Tesla’s market capitalization. After all, he stood to benefit by over $10 billion for every $50 billion increase. His equity stake was also a powerful incentive to avoid allowing Tesla to fall in what Musk might consider to be incapable hands. Moreover, Musk was not going anywhere. He stated publicly at the outset of the process and repeated throughout this litigation that he was a lifer who intended to stay at Tesla for the remainder of his days (or until he becomes “too crazy”), with or without the Grant.

Thanks to Musk’s sales of Tesla stock to fund his Twitter purchase, he now holds closer to 13% than 22%. But his reduced ownership interest still equals or exceeds what Zuckerberg owns in Meta, Bezos in Amazon, and Gates in Microsoft. As the Chancellor noted in her Rescission Ruling, the directors at those companies have determined that the founders’ existing equity interests preclude the need for further incentives via any grant of stock options.

So, at best, in Wilson-Thompson, all that Defendants have served up is a controlled director who disclaims any effort to reconsider an action that other controlled directors took, an action that was found to be a breach of fiduciary duty.  

If there ever might be a case holding that either common law or statutory ratification could unring the bell on a breach of fiduciary duty, it is most assuredly not this case, in which the Special Committee charged with re-evaluating the flawed conduct expressly refused to undertake that re-evaluation. 

D. No Exit from ‘Entire Fairness’

As the Chancellor acknowledged in her Rescission Ruling, a board of directors’ decision on how much to pay a company’s CEO “is the quintessential business determination subject to great judicial deference.”

However, where a controlling stockholder (here, Musk) stood on both sides of a transaction (the 2018 Grant) with the controlled corporation (Tesla) and received a non-ratable benefit (the 12 tranches of stock options), then, as set forth in the MFW and Match Group cases mentioned earlier, the lax business judgment rule applies only when:

1. the controlling stockholder conditions a transaction from the start on the approval of both a special committee and a majority of the minority stockholders;

2. the special committee is independent;

3. the special committee is fully empowered;

4. the special committee meets its duty of care;

5. the vote of the minority is informed; and

6. there is no coercion of the minority.

1. ‘Entirely Fair’ Is Entirely Bad for Musk

If all those protections are not present, then the Court evaluates the challenged transaction under the so-called “entire fairness” standard, which does not defer to the board’s judgment but instead requires a showing that the transaction was the product of a fair process and resulted in a fair price.

That is precisely what happened in Tornetta. The special committee that awarded Musk the stock options was not independent, the special committee did not meet its duty of care, and the misleading proxy statement meant that the vote was not informed. Consequently, the Court evaluated the 2018 Grant under the stricter “entire fairness” standard, and found that the 2018 Grant was not fair as regards either price or process.

With the Chancellor having determined that the 2018 Grant was not entirely fair to Tesla (because, among other compelling reasons, Musk was already amply incentivized by his existing equity ownership), it is difficult to imagine that the Chancellor will now change her mind and decide the 2018 Grant was, after all, entirely fair.

Defendants know this. They understand the only way they can prevail is if, somehow, business judgment supplants entire fairness as the applicable standard. So, they struggle mightily to argue for application of the business judgment rule. The phrase “business judgment” appears at least 37 times in the individual Defendants’ brief. It is almost as if they believe that by repeating “business judgment,” they can summon the standard into existence.

2. Solution: Assert Something No One Believes

Alas, the business judgment standard cannot be invoked by repetitive chanting. So, Defendants make the most audacious argument of all: that although Musk controlled Tesla for purposes of the 2018 Grant, he does not have “general control” over Tesla, and, more particularly, had no control over the ratification gambit. In support of this argument, Defendants urge (1) that the “independent” Special Committee of one, and not Musk, drove the proxy process; (2) that Musk today has less voting power than he did in 2018; and (3) that Musk is no longer Board chair.

This is gaslighting in the extreme. Tesla’s Board of Directors has been MIA for more than a decade, happy to turn a blind eye to the antics of the CEO while they stuff their pockets with cash from the munificent compensation he showers on them. Just consider recent events:

• Did Musk even ask the Tesla directors to approve his radical shift in strategy earlier this year, from being an EV manufacturer to instead focusing on artificial intelligence and robotics?

• Did Musk seek approval from those directors before forming his own AI company last March?

• Did Musk seek their approval before diverting the Nvidia chips?

If the trial record is reopened in this case, the directors will be asked to answer those questions. Under oath. And it won’t be pretty.

3. The Evidence Already in the Record

In the meantime, the question for our “kill shot” analysis is whether Defendants have, by asserting that Musk was independent for purposes of the ratification vote, managed to escape the iron grip of the entire fairness standard.

Let’s take a look at the Rescission Ruling (p. 110, footnotes omitted):

Here, Plaintiff advances theories of both general and transaction-specific control. To streamline the sprawling set of issues presented, this analysis addresses whether Musk held transaction-specific control with respect to the Grant. Because “[b]roader indicia of effective control also play a role in evaluating whether a defendant exercised actual control over a decision[,]” the sources of influence identified by Plaintiff in support of a finding of general control factor into the transaction-specific analysis.

As a threshold matter, the “transaction” at issue has not changed. It remains the 2018 Grant. The “law of the case,” as we lawyers say, is that Elon Musk controlled the 2018 Grant. Defendants contend is that the 2024 ratification vote is not creating any new transaction, but merely ratifying an old one, while at the same time they argue vigorously that the 2024 ratification vote is a new transaction altogether. This strikes me as an incoherent argument.

Further, while the Chancellor chose to “streamline” the discussion in the Rescission Ruling by focusing only on the “transaction-specific analysis,” she already has before her evidence that Musk also exercises general control over Tesla.

As with the earlier arguments, the Chancellor appears to already have sufficient evidence to conclude as a matter of law that the entire fairness standard continues to apply and that there is no reason to disturb her earlier, well-supported finding that the 2018 Grant was not fair to Tesla.

Even if the Chancellor does not settle on any of the other arguments available to Plaintiff to dispose of the ratification claim, and also agrees that Defendants have somehow raised a fact issue regarding Musk’s general control over Tesla, it seems likely that she would reopen the trial record for limited discovery on the question of Musk’s continuing control over his company.

III. Conclusion

Once one steps inside a courtroom, nothing is certain. Each of us can perform our own analyses and arrive at our own opinions. No matter how solidly grounded those opinions seem to us, and no matter how strongly we hold them, the judge remains free to arrive at a contrary conclusion.

So, while I’ve offered various reasons why Plaintiff should prevail in the ratification dispute, the only opinion that will matter is that of Chancellor McCormick. And her opinion remains TBD.

In our concluding Part 3, we’ll take a look at the dispute over “waste.” That is, would restoring the 2018 Grant amount to paying Elon Musk for past services, which is the type of wasteful action that can be ratified only by a unanimous shareholder vote?

1. Readers not already familiar with the background of Tornetta v. Musk, or wanting a refresher on some points, can find a summary in Part II of this Substack post.

2. The same warning I offered in Part 1 is equally important in this Part 2: The large legal teams on each side of this case include experts on Delaware law, which is not my legal specialty. Moreover, those large teams can engage in extensive legal research that is well beyond my capacity. Consequently, Plaintiff is all but certain to make additional arguments that I fail to anticipate in this post. As for the arguments I do discuss, Plaintiff will surely make them in a more complete and informed fashion than I can.

3. That fact is all the more stunning when one considers that Wilson-Thompson’s skills are not in manufacturing or AI or robotics, but only in human resources, where despite her six years of service (or perhaps because of them?) Tesla has compiled a decidedly abysmal track record.

4. Who is “management”? Elon Musk? I’m guessing that the vagueness of the proxy statement on this point is not accidental.