The Chancellor's Excellent Questions

The August 2 Tornetta v. Musk hearing on "ratification" is one for the ages.

I. An Historic Day in Delaware Corporate Law

One of the most important hearings in one of the most consequential cases in the history of corporate governance took place on August 2, 2024 in Wilmington, Delaware.¹ It was presided over by one of the most astute judicial officers of our time: Chancellor Kathaleen St. Jude McCormick.

(Cometh the hour, cometh the woman)

In an all-day proceeding, the Chancellor heard arguments from six different lawyers, five of whom lined up on the side of Elon Musk and his fellow Defendants. The lawyers making the arguments included some of the most highly regarded advocates in the country, including a former Solicitor General of the United States.

The prelude to the hearing was the filing of more than 200 pages of dense legal briefing. It quickly became evident that the Chancellor had mastered all the arguments: the exceptionally clever ones made by Defendants, the precedent-laden ones made by Plaintiff, the terse ones made by the amicus professor, the petulant ones made by the Tesla shareholder objectors.²

The hearing’s subject: whether the June 13 vote by Tesla shareholders to “ratify” the Board’s 2018 grant of stock options to Musk (the 2018 Grant), worth plus or minus $50 billion, depending upon the share price at the moment, was legally effective to, essentially, reverse the Chancellor’s January 30, 2024 ruling that rescinded the grant.

Chancellor McCormick is sometimes reticent at the hearings she conducts, listening carefully but asking few questions. At the August 2 hearing, however, she was exceptionally active. Her many questions and comments show a brilliant legal mind at work, and offer insight into how she views the case.

II. The Long Shadow of MFW

Crucial to understanding the arguments about ratification is the Delaware Supreme Court’s 2014 decision is the so-called MFW case.³ MFW addresses the situation where a controlling shareholder (here, Musk) stands on both sides of a transaction (here, the 2018 Grant).

MFW teaches that such a transaction can receive the benefit of the “business judgment rule” (in which courts defer to the decisions of a corporate board) rather than the much closer scrutiny of the “entire fairness doctrine” (which was applied by the Chancellor in rescinding the 2018 Grant). But to receive such deferential treatment, the transaction must meet six conditions:

1. it must be conditioned on the approval of both a Special Committee and a majority of the minority shareholders;

2. the Special Committee must be independent;

3. the Special Committee must be empowered to freely select its own advisors and to say no definitively;

4. the Special Committee must meet its duty of care in negotiating a fair price;

5. the vote of the minority must be informed; and

6. there must be no coercion of the minority shareholders.

Although the Chancellor essentially employed an MFW analysis in her January 30 ruling, it was unclear at the time whether the MFW conditions applied only to certain merger transactions.

Two months after the Chancellor’s ruling, however, the Delaware Supreme Court handed down its so-called Match decision, which established that the MFW conditions apply in all transactions where a controlling shareholder is on both sides. Thus, the Chancellor’s use of the MFW framework was vindicated, and in evaluating Defendants’ ratification attempt, the MFW conditions take on a special importance.

For our purposes, there are two key points to be made about the MFW protections. First, some of those protections must be in place before a controlling shareholder transaction is negotiated. Second, in a compensation transaction (such as the 2018 Grant), the Special Committee must take pains to negotiate a fair price by, among other things, performing a so-called “benchmarking analysis” in which the proposed compensation is compared with the compensation awarded to corporate officers at other similar companies.

Beyond question, Defendants’ “ratification” effort satisfied neither of those two conditions. The shareholders at the June 13, 2024 annual meeting voted to ratify a transaction that had been negotiated six years earlier, in which Tesla’s board had made no effort to put the MFW protections in place before it awarded Musk the 2018 Grant. Second, neither Tesla’s Compensation Committee nor its Board of Directors as a whole engaged in any benchmarking analysis before making the 2018 Grant.⁴

Consequently, Defendants’ arguments at the August 2 hearing were largely an attempt to urge that the MFW conditions are inapplicable to the ratification vote.⁵

So what did Defendants argue? Their essential pitch is that the process leading up to the June 13 ratification vote was even better than a process satisfying the MFW rubric. That process included “a very vigorous and very public debate” in which shareholders had the benefit not only of the Court’s 200-page January 30 rescission ruling, but also detailed analyses by proxy advisory services and countless news stories.

With such an “incredibly unique” process culminating in a 72% approval vote, Defendants insist that the Chancellor must respect the voice of the “ultimate economic interest holders.”

III. The Chancellor’s Many Questions

As already mentioned, the Chancellor had several probing questions for Defendants’ counsel. Indeed, at times, the hearing resembled a Socratic dialogue more than an oral argument. As you follow the course of the discussion, observe how the Chancellor’s questions lead Defendants’ counsel ever further into an impenetrable thicket of increasingly implausible arguments.

A. Can a Breach of Fiduciary Duty Ever Be Ratified?

Counsel for the Defendant Directors, David Ross, was wading into his argument about the sanctity of the “stockholder franchise” when the Chancellor interrupted to ask whether he could cite any case that permitted common law ratification⁶ of “an adjudicated breach of the duty of loyalty.”

Ross danced around the question, insisting that Defendants were not arguing that the vote changed the Court’s adjudication “with respect to conduct.” Rather, the vote merely changed the Court’s remedy of rescission. “[T]he findings, the opinion would otherwise all remain intact,” said Ross.

After a bit more discussion, the Chancellor returned to her question:

So let me just ask it again. Is there a single case in which common law ratification has been invoked to ratify an adjudicated breach of the duty of loyalty?

Ross conceded that no such case existed⁷ while also asserting that neither was there any case saying that common law ratification cannot achieve such a result.

“So,” asked the Chancellor, “this has never been done before?”After a bit more rhetorical contortion, Ross finally admitted that, “Yes,” this has never been done before.

Thus, with these questions, the Chancellor established that for her to rule in Defendants’ favor, her Court of Chancery, which is subordinate to the Delaware Supreme Court, would be placed in the position of establishing a completely new legal doctrine.

B. What About MFW?

The Chancellor then noted that, because the 2018 Grant failed to meet the conditions set by MFW, the 2018 shareholder vote was ineffective to cause the 2018 Grant to be reviewed under the lax business judgment rule.

Given that the shareholder vote was insufficient to restore the business judgment rule before she made her rescission ruling, then why, she asked, should the shareholder vote “standing alone” (that is, without all the MFW conditions being met) after she had made her rescission ruling, “be more powerful than before trial?”

Ross’s response was that, in this instance, the Tesla shareholders “have the benefit of something that is even stronger, which is Your Honor's [January 30, 2024] opinion.” Absent from his answer, of course, was any mention of legal precedent to support his assertion.

THE CHANCELLOR: You're saying that the stockholders are able to ratify a transaction with a conflicted controller based on a fully informed, uncoerced vote even in circumstances where there's no fully empowered special committee placed up front for the purpose of negotiating, at arm's length, that transaction?

* * * * * *

ATTORNEY ROSS: So I think that the failure -- that you can reach a point where, yes, the stockholders can seek to make clear their desire to have the benefit of the transaction.

THE COURT: Without the special committee process called for by MFW?

ATTORNEY ROSS: Yes.

Thus, by her line of questions, the Chancellor established that to rule in favor of Defendants, she — a mere lower court judge, subordinate to Delaware’s Supreme Court — would need to establish a rather dramatic exception to the Match/MFW rule laid down by that supreme court only several months ago. As she later said, “that’s a difficult conclusion to reach in terms of its legal legitimacy, knowing that our high court said that that [the MFW protections] needs to be in place at the outset.”⁸

Moreover, Ross’s answer — that the June 13 shareholder vote was “stronger” than the MFW protections because in casting their ballots, the shareholders had the benefit of the Chancellor’s rescission ruling — very nicely opened the door to the Chancellor’s third concern.

C. Isn’t Common Law Ratification a Defense Rather than a Means of Overturning a Ruling?

The simple fact, well-established in Delaware and elsewhere, is that common law ratification is a defense to a legal claim, and not an affirmative claim itself, or a tool that can be employed to undo a legal ruling that has already been made.

Plaintiff in Tornetta argued that Defendants waived the defense of common law ratification by failing to attempt the new proxy process and the new shareholder vote before the case went to trial in November of 2022 (or, at the very least, before the Court issued its January 30, 2024 rescission ruling).

The Chancellor asked Ross if she correctly understood him when he said that the post-ruling ratification vote was even “stronger” than MFW protections because at that point, the shareholders have all the information that is “typically only included in the final trial court decision.”

Yes, said Ross, that’s correct.

The Chancellor:

So next question. How do you square that view with the idea that common law ratification is an affirmative defense that folks waive if they don’t raise it before trial?

Ross responded that, given the remedy in this case of rescission, which is easily undone, it is unnecessary to have the common law ratification vote occur before trial.

The Chancellor then asked, “What if I had ordered rescissory damages, as opposed to rescission [of the stock options grant]? Could your argument still work?

Ross now went further out on the limb. Yes, the argument would still work if the Court awarded damages.

What about any other remedy? Yes, any remedy at all.

All the way out on a limb now, Ross finally took the position that the only remedy for which a ratification vote would not work would be the award of “the costs to the company for the ratification vote itself.”

So, asked the Chancellor, “You're saying the only remedy that that vote couldn't eliminate is the cost of the vote?” With his extreme position exposed in such stark terms, Ross offered what amounts to a stammering word salad:

ATTORNEY ROSS: So I want to be -- as I said, and I apologize if I wasn't clear, I can't say I've thought through every conceivable remedy and what the effect would be, but what we do think is, in the context of this remedy or a different remedy that is in effect, the remedy that seeks to speak to a perceived failure of proof, for example, with respect to the failure of the transaction, that a damage award based on that or rescission of that, in the face of the stockholder saying we want this, we do not believe that that nature of remedy would be available. We believe that is the effect of ratification.

An affirmative defense that can negate even an adjudicated damages award has never before been seen. And it’s unlikely it will be seen this time.

D. When Does a Court Case Finally End?

In a real sense, it is only by accident that the June 13 shareholder vote occurred before the Court issued a final order in Tornetta.

The core ruling — a finding of breach of the duty of loyalty coupled with the remedy of rescission — occurred in the 200-page opinion handed down on January 30. At that point, the only remaining issues to be resolved were the award to Plaintiff of (1) “costs” (filing fees and various other out-of-pocket costs), and (2) legal fees.

Calculating the “costs” was simple, as the allowable categories of costs are clearly spelled out. Legal fees was another matter; the magnitude of savings to Tesla shareholders resulting from wiping out 304 million Musk shares, along with the fact that Plaintiff requested the fees in shares of stock rather than cash, created a complex set of legal questions. That complexity, along with Defendants’ determined effort to keep their ratification gambit secret as long as possible,⁹ is the reason there was no final order well in advance of June 13.

So, the question that naturally occurs is whether, in Defendants’ view, their common law ratification effort would have been legally effective even if the shareholder vote had come after the entry of a final, appealable order. Chancellor McCormick posed that question to attorney Ross.

You've also made the point that it [common law ratification] can work here because I have not yet entered a final form of order implementing the decision.

What if I had? What if I had entered that before the stockholder vote? Would this argument still work?

Yes, said Ross. The common law ratification still would be legally effective even if the shareholder vote came after a final order were entered.

Okay, then, she said. What about after the Delaware Supreme Court had issued its decision on appeal? What if the Delaware Supreme Court affirmed her judgment, and the shareholder vote for common law ratification occurred only after that affirmance?

His answer was “yes.” Indeed, the additional legal decision from the highest court “unquestionably” would make the shareholder vote even “more informed.”

This was a jaw-dropping moment. The idea that shareholders can overrule a trial court, never mind a state supreme court, is simply staggering. There is no legal authority for that view and, as counsel for Plaintiff later pointed out, it is contrary to the Delaware Constitution.

The notion of “finality” is a vital one in the legal world. At some point, a decision must be final. There must be certainty about the outcome, not only for the parties to the litigation, but also for others who are relying on the stability of the outcome.

It is exceedingly improbable that a chancellor in the Court of Chancery is going to fashion a brand-new doctrine that undermines the concept of finality by enabling a shareholder vote — at any time, even years after a legal ruling — to reverse such ruling.

E. Tell Me Again What You Told the Shareholders . . .

The Chancellor indicated some displeasure with the “innumerable times” the Proxy Statement informed Tesla shareholders that they were engaging in “ratification” when “there's no Delaware case that's allowed for common law ratification to operate as you told them it would.”

At one point, she served up a dish of words for attorney Ross to eat. As we already saw, early in the hearing, in trying to soften the lack of precedent for common law ratification as a cure for a breach of fiduciary duty, he had insisted:

I do want to be very clear. We are not asking for the effect of the vote to change the Court's adjudication with respect to the conduct. As I said, we're not asking for a change of factual findings. We're not asking for a different legal conclusion. We're asking only for a modification of the remedy.

Chancellor McCormick had Ross read language directly from Tesla’s proxy statement:

If the 2018 CEO Performance Award is ratified by our stockholders at the 2024 Annual Meeting, the Company believes []: the deficiencies, including disclosure deficiencies, procedural deficiencies, and breaches of fiduciary duty, identified by the Delaware Court in connection with the Board and our stockholders’ original approval of the 2018 CEO Performance Award should be ratified and remedied, and any wrongs found by the Delaware Court in connection with the 2018 CEO Performance Award should be cured[.]"

Obviously, the Proxy Statement promised that “ratification” could do much more than simply change a remedy. It could, instead, “cure any wrongs” including “breaches of fiduciary duty.”

When Ross completed his reading assignment, McCormick said, “So that strikes me as contrary to what you said earlier about what you're seeking here today and what -- what ratification can do.” Later, she added, “I think it's fair to say that it was a pretty foolish position taken in the proxy about the scope and breadth and ability of the stockholders to so-call ratify, ratify the transaction and more.”

It was one of those unfortunate moments in which a capable advocate finds himself in the impossible position of having to defend his clients’ arrogance.

F. Why Can’t the Board Just Grant a New Compensation Package?

David Ross, representing the individual Defendants, wasn’t the only attorney placed on the hot seat. The Chancellor also had some tough questions for Rudolf Koch, who represented Tesla in its role as nominal Defendant.

Part of Defendants’ argument has been that Tesla would incur a massive accounting charge (more than $25 billion) if it has to grant Musk a new compensation package with the same economic benefit as the 2018 Grant. Moreover, as was suggested during the hearing, Musk might face added excise taxes from a new grant. Referring to those concerns, the Chancellor asked Koch:

So why isn't the response to those concerns, the accounting charge to Tesla through a replacement compensation package and the tax charges, why wouldn't that be accounted for in a genuine arm's length negotiation, you know, that occurred in connection with the new transaction? And why would any harm that befalls from the new transaction fall to Tesla or its stockholders and not the persons who breached their fiduciary duty?

Koch replied that the Chancellor was asking for the shareholders to compensate Musk less than they wanted to. She immediately pushed back:

No, I'm not saying that. I'm saying a new transaction would be subject to an actual process that involved negotiation in which these concerns could be raised.

Koch then accused her of taking away the shareholders’ choice to have the original package restored. She immediately responded;

The stockholders didn't have an option to take a new deal. The board gave them one option.

I think this is exactly right; it is the $25 billion threat I recently wrote about.

Koch continued to accuse the Chancellor of taking away the shareholders’ choice. And so she made it a point to explain that it was, in fact, the Directors who gave the shareholders only the miserable choice of a $25+ billion accounting charge:

So let me just go back. There are two paths, okay? I issued the decision.

The board wants to give Mr. Musk compensation, replacement compensation. Two paths. There's the uncharted path of common law ratification after a post-trial decision; and there's the other path, which is decide how to structure a new transaction, okay?

So in my simplistic view, the stockholders did not choose which of those two paths to go down. The board did. The board chose the uncharted course, okay?

Yes, the Tesla Board did exactly that. It coerced the Tesla shareholders into a favorable “ratification” vote by offering only one terrible alternative choice: a $25+ billion compensation expense. In doing so, it chose the “uncharted course” of wild new legal theories rather than the well-defined pathway lit by the MFW conditions.

That well-defined pathway would, no doubt, have resulted in Elon Musk getting a compensation package somewhat less valuable than the 2018 Grant. But it would all the same have resulted in him far greater compensation than any other CEO in history.

(Oh, did I just write that the Tesla Board chose the uncharted course? We are all well aware, of course, that the Tesla Board makes no significant choices. It was Elon Musk who ultimately made that choice.)

V. The Arguments Hardly Mentioned

As I wrote in my posts evaluating the briefing, Plaintiff badly wants a legal “kill shot” that disposes of Defendants’ ratification argument. In other words, Plaintiff hopes the Court will dispose of the case without having to reopen the trial record to disprove the following patently false claims by Defendants:

• “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.”

Plaintiff was no doubt pleased that the Chancellor focused her attention on the purely legal arguments, and showed little interest in fact-intensive arguments.

The need for “finality” in judicial decisions most certainly cuts against any reopening of the trial record to explore Defendants’ disputed contentions about the purity of the proxy process. Plaintiff’s attorney, Greg Varallo, made that point in a pithy and powerful paragraph, detailing what would follow were the Court to grant Defendants’ request to reopen the record to admit the “newly created evidence” that culminated in the shareholder vote:

If granted, I would suggest to you the application would call into question the independence of the special committee, the special committee's process, the withdrawal of one of its members, the request of the remaining member for an additional independent director, the denial of that request, the independence of the board who voted to put the issues to stockholders, the nature of the coercion that I previously argued, the control demonstrated by Musk throughout the process generally and specifically, the sufficiency of the proxy used to solicit votes, the nature of the early claim of victory Mr. Musk made, and any deals made or other acts of persuasion taken to secure votes in connection with the lobbying effort undertaken to get the ratification vote. But I digress.

Those who have been following my Substack posts, including those in which I had the capable collaboration of an experienced Silicon Valley corporate attorney with board experience at several large tech companies, will appreciate how lovely is that summation of Defendants’ factual claims that will not stand scrutiny.

VI. A Most Important Hearing in a Most Consequential Case?

Yes, I made that claim in my introduction. Here is why I hold that opinion.

The Tornetta case has, in dollar terms, the second largest judgment in history. Only the 1998 tobacco settlement was greater, and the payments there were spread out over 25 years. That alone makes the August 2 hearing important and the Tornetta case consequential. But there are far more important reasons.

• Elon Musk cares nothing for the law. In his view, he is the law.

• He cares not a whit about environmental law, which is why Tesla’s Fremont plant has been endlessly cited for violations and why residents near his Texas SpaceX facility are distraught at the destruction he has wrought.

• He cares even less about labor law, which is why his companies regularly face legal action over racial discrimination and unsafe workplaces.

• He has utter contempt for securities laws, which is why he felt so secure in his 2018 lie that he had “funding secured” for a take-private transaction; then thumbed his nose at the consent decree requirement that his tweets about Tesla’s business receive advance review; and then announced that the SEC could “Suck Elon’s C*ck.”

• He acquired Twitter stock with complete disregard for his reporting obligations under Section 13 of the Securities Exchange Act of 1934.

• He continues to tell outrageous lies about Autopilot and Full Self-Driving. The famous “Paint It Black” video is every bit as misleading as Trevor Milton’s video of the Nikola truck rolling down a hill and Elizabeth Holmes’ photo with a blood capsule, with the significant difference that no one died because of the lies of Milton or Holmes.¹⁰

• He has cozied up to Russia. He has undermined Ukraine’s attempt to defend itself. He has bowed and scraped before Chairman Xi.

• He has acquired his galactic wealth thanks principally to governmental subsidies and mandates and governmental contracts. Without taxpayers and ratepayers generously subsidizing his ventures, he would be just another loudmouth multi-millionaire.

• His reaction to the Chancellor’s January 30 Tornetta ruling was to lambaste the Court, urge other companies to reincorporate in Texas, foment anger at the Court among his large and mindless cult, and have his Tesla Directors — all marionettes on his string — do exactly as he instructed in the ratification gambit.¹¹

Standing against this arrogant narcissism has been a single courageous judicial officer. The one who forced Musk to honor his contract to purchase Twitter for $44 billion by making careful, thoughtful, and rapid rulings. And the one has been fearless and brilliant throughout the Tornetta case.

We need more like her.

VII. What Now?

The Chancellor took the matter under advisement. We can expect a detailed opinion on legal fees and ratification before year-end, possibly before November.

I believe the ruling will come with an award of costs and legal fees to Plaintiff, and a final order implementing the rescission of the 2018 Grant. The next stop will be the Delaware Supreme Court.

1. I speak, of course, of Tornetta v. Musk. Readers not already familiar with the background of the case, or wanting a refresher on some points, can find a summary in Part II of this June 6 Substack post. I appreciate that my opinions about the crucial importance of Tornetta cry out for some explanation. I will offer some at the end of this post.

2. The objectors included ARK Investment Management LLC, managed by the infamous Cathie Wood.

3. The full name of the case is Kahn v. MF Worldwide Corp. (often referred to as MFW).

4. The Tesla board skipped a benchmarking analysis for the obvious reason that such an analysis would have shown that the 2018 Grant exceeded by two magnitudes the compensation that had ever been awarded to any other public company CEO.

5. Plaintiff also asserted that the Special Committee was not independent, that the proxy materials failed to fully inform the shareholders, and that the shareholder vote was coerced. Most or all those challenges, while powerfully supported by evidence, would require the Court to reopen the trial record and allow more discovery. Our focus here is on the purely legal arguments that can resolve the case without requiring another time-consuming and expensive round of fact-finding.

6. Tesla’s proxy statement told its shareholders that their vote was being solicited to achieve a ratification under either Delaware’s unwritten common law (“common law ratification”) or under Section 204 of the Delaware General Corporation Law (“statutory ratification”). Yet after Plaintiff pointed out the very obvious defects in the statutory ratification argument, that argument essentially disappeared from Defendants’ briefing. Consequently, all Defendants’ references to “ratification” at the August 2 hearing were to common law ratification only.

7. All as foretold in Part III.B. of this Substack post.

8. Ross also argued that it is unlikely that a controlling shareholder would risk enduring lengthy and expensive litigation, and depend on a favorable shareholder vote, simply to avoid the strict MFW conditions. The Chancellor then recalled a law journal article from a preeminent scholar who discussed how “repeat players in fiduciary litigation” are incentivized “to force plaintiffs’ attorneys to take a case through litigation” because of the resulting “obstacles and nuisance value,” and asked whether Delaware law should not concern itself with that type of “moral hazard.” Ross said he saw no such moral hazard. (Regardless of whether such a moral hazard exists, who comes to mind as a “repeat player” in “fiduciary litigation”?)

9. You can find the details about Defendants’ stall tactics in the 2024 portion of the chronology in Part II of this Substack post.

10. [Post-publication note: a reader has pushed back, arguing that Holmes’ fraud “likely” resulted in deaths. I take the point that we cannot know for certain, but know of no claim that any such death occurred.]

11. Joe Gebbia, who declined to participate in the ratification gambit, being a possible exception.