The Tesla Party Was Fun; Now Comes the Hangover

The shareholder vote is Elon's last hurrah. Now comes a tsunami of lawsuits and a world of hurt for the company, the directors, and especially the shareholders.

With Tesla’s shareholders having voted to “ratify” the 2018 stock option compensation package awarded to Musk (the 2018 Grant) and to have the company reincorporate in Texas, let’s review where things stand, both with the Tornetta v. Musk case and with four other derivative lawsuits filed against the Tesla directors in Delaware during the past several days.

Those unfamiliar with the background of Tornetta, or wanting a quick refresher, can find one at Part II of this Substack post. Those wanting to read the clearly written and carefully reasoned 200-page Post-Trial Opinion, which rescinded Tesla’s 2018 grant of stock options to Elon Musk (the 2018 Grant), can find it here.

(graphic generated by Microsoft Designer AI)

I. Tesla Is a Texas Corporation

Tesla wasted no time reincorporating in Texas, as evidenced by the 8-K it filed to report on the votes at the shareholder meeting.

The Texas “Business Court” Tesla has chosen to handle its internal governance disputes was only recently formed by enacting legislation, and no judges have yet been appointed. That court is scheduled to begin operations on September 1. In the meantime, those internal governance disputes must be filed in the federal district court for the Western District of Texas or, if federal jurisdiction is lacking, in the state district court of Travis County, Texas.

The Texas governor (currently, Greg Abbott) will appoint the Business Court judges for two-year renewable terms. The Third Business Court, which covers Travis County, will have two judges. I don’t think it is fanciful to imagine that Elon Musk and his proxies will have some very precise suggestions for Governor Abbott about the identity of the Third Business Court appointees. In fact, it would be naive to imagine otherwise.

Significantly, the Texas Constitution requires that Texas state court judges be elected. It is all but certain that once the Business Courts begin handing down judgments, the losing litigants will challenge those judgments as unconstitutional. Eventually, the Texas Supreme Court will have to decide the matter.

So, built into the Tesla decision to reincorporate in Texas is a large element of uncertainty, at least for some time to come. Moreover, as discussed in Part III of this post, the effectiveness of the reincorporation itself faces a legal challenge in Delaware.

II. Tornetta Just Became More Complicated

The issue of whether the “ratification” is legally effective will now be squarely before the Chancellor in Tornetta. Procedurally, things could now become quite complicated. Here is what I anticipate:

A. Legal Fees Issue

The parties have filed their opening briefs on Plaintiff’s request for legal fees (Plaintiff is seeking a portion of the 304 million shares it recovered for Tesla). Plaintiff will file its reply brief by June 21, the Court will conduct an oral hearing on July 8, and I would anticipate a decision will be handed down within a few weeks thereafter.

The decision will be complex because the award sought is so large when translated to dollar terms. Essentially, simply because of the magnitude of the case, the Chancellor will have to make new law. But I would guess she will have begun working on an opinion in advance of the July 8 hearing, so it is not unreasonable to expect an opinion and ruling within a relatively short time thereafter.

B. The ‘Ratification’ Issue

Defendants undoubtedly will now urge to the Court that the shareholder vote has, in effect, erased her January 30 rescission ruling. (I would expect a motion may well be on file before I can publish this.)

In response, Plaintiff will urge that, for a host of reasons, the shareholder vote was legally ineffective. Plaintiff is likely to make the following arguments (and perhaps others that I have not anticipated):

• Section 204 of the Delaware General Corporation Law, on which Tesla’s ratification effort is premised, instructs how to cure a “corporate act” that is “defective” by reason of “a failure of authorization.” Plaintiff will urge that the statute is designed to correct technical problems with statutory authorization, but that it cannot cure breaches of fiduciary duty. In his proposed amicus brief, Professor Charles Elson reached that conclusion in detailing the existing case law under Section 204, and it is all but certain that Plaintiff will offer the Court essentially the same analysis.¹

• As Professor Ann Lipton pointed out in a blog post published the day after Tesla’s April 17 proxy statement was released, Delaware law (with exceptions not here relevant) does not permit the award of compensation as a reward for past work that has already been accomplished. So, restoring the 2018 award would fall into the legal category of “waste,” which can be ratified only by a unanimous shareholder vote. The shareholder vote was far from unanimous. (Professor Elson’s amicus brief also discusses this law, and he agrees with Professor Lipton.)

• Plaintiff will urge that in recommending the “ratification” of the 2018 Grant, Tesla’s Special Committee (of exactly one member) failed to comply with the requirements set forth in the Delaware Supreme Court’s decision in In re Match Group, Inc. Derivative Litigation, which was handed down in April. That decision would appear to require that the award granted to Musk be made by a truly independent committee, undertaking genuine negotiations, and guided by outside consultants. Plaintiff will argue that all three of those elements are absent here. The single member of the Special Committee recommending the “ratification” was a deeply compromised Kathleen Wilson-Thompson. She expressly declined to negotiate with Musk, and expressly declined to engage any outside compensation consultant. (Professor Elson’s amicus brief has something supportive to say about this, as well.)

• Plaintiff will urge that the April 17 proxy statement that informed the vote, as well as many of the proxy materials filed thereafter, are materially misleading by omitting many material facts and misrepresenting other material facts. Writing with a capable collaborator, I detailed many of those failures in this Substack post, and there have been even more arguably false assertions filed as proxy materials since that post (including the assertion that Musk cannot sell the stock underlying the options for five years when, in fact, he is free to start selling the shares immediately to pay the strike price and income taxes).

• Plaintiff may argue that the entire shareholder vote is ineffective because it was orchestrated entirely by Musk, using a coercive process in which he, in effect, extorted the favorable votes under threat of further stripping Tesla of its artificial intelligence and robotics capabilities.

The first and second bullet points above are purely legal in nature. The Court could rule on them without further discovery. The third, fourth, and fifth bullet points are fact-intensive, and would require an extended period of discovery (gathering documents, deposing witnesses, etc.) before any ruling could be made.

I will go out on a limb and predict that the Court will make a legal ruling, denying Defendants’ motion for one of those first two reasons, and indicating that because that reason is sufficient, she need not reach Plaintiff’s other arguments (which will still be available to Plaintiff on remand in the event any appeal is successful).

The Chancellor will, after making such a ruling, enter a final, appealable order, and Defendants will then appeal her decisions (on rescission, legal fees, and ratification) to the Delaware Supreme Court.

III. Four More Breach of Fiduciary Duty Lawsuits

Since my last post, litigants seeking to stand in the shoes of Tesla have filed four new “derivative” cases in the Court of Chancery, bringing a variety of breach of fiduciary duty claims against Musk and the other Tesla directors.

To some extent, the misdeeds alleged in the four cases overlap. All those cases rely on, and benefit from, the detailed fact findings in the Chancellor’s Tornetta decision which, as some predicted (particularly the poster who is k_salberta at Threads and X), has helped opened the floodgates for litigation to hold the Tesla directors to account for years of wrongdoing.

Each of these complaints appears on its face to have merit. Each will be very costly to defend. Each exposes Musk and the other directors to significant potential liability. Collectively, they cause one to wonder whether and to what extent Musk and his fellow directors still have available to them third-party Directors & Officers insurance coverage.

The four cases,² in reverse chronological order, are:

A. The Corporate Opportunity Doctrine Case

Cleveland Bakers & Teamsters Pension Fund, et al. v Elon Musk, et al. This 73-page complaint (filed several hours before Tesla reincorporated in Texas) alleges that Musk has breached his fiduciary duty by forming his own artificial intelligence start-up, X.AI Corp. (xAI), which is competing against Tesla. The suit claims that the Tesla directors breached their fiduciary duty by, essentially, looking the other way and doing nothing.

The complaint is impressively researched and powerfully written. It includes some recent details, including the June 4 blockbuster report by CNBC’s Lora Kolodny about Tesla’s diversion to Twitter of a large shipment of Nvidia’s highly sought-after H100 graphics processing units. (Elon Musk responded by tweeting that Kolodny is a liar, then essentially confirmed her reporting by offering a strange explanation, which turned out to be at odds with an equally strange explanation offered by Tesla Chair Robyn Denholm, who undoubtedly was told of the diversion only after the fact but decided to take to the airwaves to defend Musk anyway.)

The “Substantive Allegations” portion of the complaint’s Table of Contents concisely summarizes the allegations:

Anyone denying the peril this case presents has not read the complaint.

Also, kindly allow me to say, “I told you so.”

B. The Tesla & Twitter Case

The Employees' Retirement System of Rhode Island v. Elon Musk, et al. This complaint, with immense detail in its 241 pages, was filed on June 10. It alleges that Musk violated his duty to Tesla’s shareholders by selling Tesla stock and diverting Tesla resources as he attempted to acquire Twitter. It includes detailed allegations against Elon’s brother, Kimbal, in misleading shareholders about massive sales of Tesla stock and in trading on insider information.

The complaint alleges that the activities of the Elon Musk in connection with the Twitter acquisition were plain violations of Tesla’s Code of Ethics. It alleges that, as they have always done in the past, the directors again chose to look the other way, and similarly chose to do nothing about Musk’s serial violations of the 2018 SEC consent decree that required prior review of Musk tweets.

Plaintiff seeks disgorgement of billions of dollars in proceeds from sales of Tesla stock, monetary damages, disgorgement of Musk’s equity interest in xAI (alleged to be a Tesla corporate opportunity usurped by Musk), and numerous other items of equitable relief.

C. The Reincorporation Case

Donald Ball v. Tesla, Inc., et al. This complaint, filed on June 6, likewise sues Musk and all the other Tesla directors. It challenges not only the ratification attempt, but also the reincorporation, and alleges that the entire shareholder vote is void because coerced by Musk’s threats to move his artificial intelligence and robotics activities out of Tesla and into other companies he controls.

I suppose it is flattering that, in two places (¶¶ 33-35, 74-76), the Ball complaint quotes from one of my Substack posts (identifying me as a “commentator”) and that in a third (¶ 85), it relies heavily on another Substack post (albeit without attribution).

For the reasons detailed by Professor Ann Lipton, I find the reincorporation argument in Ball to be problematic. (However, under Vice Chancellor J. Travis Laster’s recent TripAdvisor decision, an “entire fairness” challenge to Tesla’s reincorporation might be possible. I need to give that one some more thought.)

D. The Insider Trading Case

Michael Perry v. Elon Musk, et al. The Perry complaint, filed on May 24 (and in redacted form for public view on May 30), accuses Musk of reaping more than $7.5 billion in proceeds from stock sales in late 2022, at a time when he allegedly knew Tesla’s Q4 delivery numbers would be disappointing, but before Tesla finally revealed the delivery data on January 2, 2023.

It further alleges that Tesla’s directors, who are also defendants, did absolutely nothing to enforce against Musk Tesla’s own internal Insider Trading Policy.

IV. The Real Pain Is About to Begin

After the jubilation of yesterday’s shareholder vote will come the hangover of reality. A tsunami of bad fortune is about to engulf Tesla shareholders.

First, some of the institutional shareholders who opposed the ratification and reincorporation gambits may well have decided it is time to take their profits and exit stage right.

Second, during the next month, Tesla will report disappointing Q2 delivery numbers and even more disappointing Q2 financial results. Further downgrades in the analysts’ earnings estimates and price targets may well follow. With a swelling inventory, determined competition (especially in Europe and China), and a diminished appetite for EVs among U.S. consumers, Tesla will be forced to offer even more margin-eating price cuts and incentives. My guess is that Tesla’s earnings per share for 2024 will be in the range of $2.00 (well down from 2023’s $4.30), and even the $2.00 figure may be optimistic.

Third, notwithstanding many beautiful renderings, lovely models, and optimistic promises at the August 8 robotaxi reveal, the reality that Tesla has no functioning robotaxi, and is unlikely to have any such robotaxi for years to come (if ever), will soon sink in. JPMorgan has already received such news straight from the horse’s mouth.

Fourth, that reality will be especially painful in view of Tesla’s decision to postpone, if not altogether abandon, its plans for a $25k “Model 2” built with a revolutionary “unboxed” manufacturing process. So, for some time to come, Tesla will be stuck with its existing model lineup which, except for the Cybertruck (a niche product at best) is growing old and tired.

Fifth, Tesla shareholders will discover that their ratification vote does not translate into an immediate award to Musk of the 304 million shares from the 2018 Grant. Instead, protracted litigation will ensue over the effectiveness of that vote. Musk will be frustrated and enraged by the refusal of the Delaware court to bend to his will. He may well attempt to persuade Tesla’s Board of Directors to award him the shares, with or without the help of a crooked Texas Business Court judge (because it would take a crooked judge to pretend to wrest jurisdiction of Tornetta away from the Court of Chancery), and Delaware be damned. If the board actually takes such a step, then chaos will erupt on a scale almost impossible to imagine.

Sixth, if, whether in defiance of Delaware or otherwise, Musk does manage to get his hands on the 304 million shares and begin selling them (which he is allowed to do, proxy materials to the contrary notwithstanding, in order to pay the strike price and income taxes), then the downward pressure on the Tesla share price is likely to be material.

Seventh, even those 304 million shares will likely not sate Musk. They may get him to about 17% ownership based on the existing share price (for details, see the superb analysis at jaberwock’s Newsletter), but Musk has said that unless he has closer to 25%, he will remain “uncomfortable,” and hence inclined to continue misappropriating Tesla’s business opportunities:

Eighth, as the Tesla share price plunges, its cash evaporates, and its profits shrink, some shareholders may wonder why the Board of Directors didn’t include a clawback in the 2018 Grant that would allow Tesla to recover some of the shares awarded to Musk if the market cap and operational achievements began to melt away (as they already have). Those shareholders may begin to present to the directors even more difficult questions, and more troublesome litigation, than they already face.

So, buckle up. The real fun is about to begin.

V. The Root of the Problem

How did things come to such a pass? How did we get to the point where Musk has defied the auto safety regulators, the consumer protection regulators, and the SEC, and may even be prepared to defy a court order from Delaware’s Court of Chancery?

How did we reach the place where Tesla shareholders decided to cave to Musk’s coercion and extortionate demands to protect what they know is a wildly inflated share value?

How did we arrive at a situation where the shareholders would rather have Musk behaving recklessly because they know the share price is wildly disconnected from Tesla’s fundamentals, and fear that without Musk, the fraud can’t go on?

Those questions are the topic for another post.

1. Professor Elson sought permission (by means of a so-called “motion for leave”) to file his amicus brief on May 13. The Defendants opposed his request as untimely and as an effort to influence the shareholder vote. The Court has not yet ruled on Elson’s motion, likely because the issue of whether the shareholder vote was effective to ratify the 2018 Grant was not yet in the case. That issue is most assuredly now in the case. I anticipate the Court will rule on Elson’s motion soon, and likely will grant it. You can find further background in this Substack post.

2. These four cases are, of course, in addition to the myriad breach of contract and personal injury cases pending against Tesla, as well as the ongoing investigation by the Department of Justice over the self-driving claims of Tesla and Musk and the ongoing investigation by the Securities and Exchange Commission (SEC) regarding Musk’s Twitter acquisition, including for so-called Section 13 reporting requirements.