Last week, a judge in Delaware rejected Tesla (TSLA) CEO Elon Musk’s infamous $56 billion pay plan, approved by the electric carmaker’s board in 2018. Business law experts say the ruling set a rare precedent and could have major implications for how large public companies pay their top executives.
Kathaleen McCormick, chancellor of the Delaware Court of Chancery, began her 201-page ruling by asking, “Was the richest person in the world overpaid?” Citing poor corporate governance and a compensation package too driven by Musk himself, she concluded, “yes.” The lawsuit was brought upon in 2018 by a Tesla investor owning a single-digit number of shares, but the case was ultimately decided on behalf of all Tesla shareholders.
Musk can appeal the decision in the Delaware State Supreme Court; he has also threatened to move the jurisdiction of incorporation of Tesla from Delaware to Texas as a potential way to end the legal headache.
What’s in Elon Musk’s $56 billion pay package?
In March 2018, the compensation committee of Tesla’s board approved a plan that would award Musk with stock options in 12 tranches over ten years if he can meet a set of lofty performance goals, including growing Tesla’s market capitalization to $650 billion, more than 10 times the company’s value at the time. The pay plan was created to incentivize Musk to grow Tesla’s market value and make sure that his compensation is “100 percent aligned with the interests of our stockholders,” Tesla said in a proxy statement in February 2018.
Tesla valued Musk’s pay package at $2.6 billion in 2018. But at the targeted market cap that would allow the CEO to get paid, the package would be worth a whopping $55.8 billion. Musk became eligible to receive his first payout in 2020 after Tesla’s stock price soared. In 2021, the company’s market cap briefly surpassed $1 trillion.
McCormick argued that Tesla’s board lacked members with independence from Musk to provide necessary oversight and that the 2018 proxy statement to shareholders included misleading statements.
“The Board never asked the $55.8 billion question: Was the plan even necessary for Tesla to retain Musk and achieve its goals?” McCormick wrote in the ruling. She noted that Musk already owned nearly 22 percent of Tesla in 2018 and there’s no evidence he would threaten to leave the company if not given extra compensation.
Additionally, McCormick argued that it was not clear to shareholders the level of influence Musk had in forming his compensation plan: he proposed the amount along with the conditions and payout timeline with little pushback. The board’s compensation committee also failed to show it independently benchmarked Musk’s compensation to the remaining industry; $55.8 billion is six times larger than the total pay received by the 200 highest-earning executives in 2021 combined, according to executive pay research firm Equilar.
How could Delaware’s final ruling affect CEO pay?
Management and legal experts are split on whether the Delaware decision will set a new standard for corporate governance. The final outcome of the lawsuit could impact 65 percent of all Fortune 500 companies and more than half of all U.S. publicly traded companies that are incorporated in the tiny northeast state.
“My takeaway from this decision is that companies should ensure they have board independence, have a sound process with oversight for compensation decisions, and maintain accuracy in any statements made to shareholders,” Justin Klein, director of the University of Delaware’s Weinberg Center for Corporate Governance, told Observer.
However, some scholars doubt if true board independence is even realistic. “There is much academic writing about how there is no such thing as a truly independent board,” Melissa Schilling, a management professor at the New York University, told Observer. She said it’s natural for board members to develop friendships with their CEO over time, especially if they have supported the company through difficult times as some of Tesla’s board members have.
Ann Lipton, a professor of business law at Tulane University, said the Delaware decision does not create a new standard but instead holds Tesla to the same one others abide by. “Courts rarely second guess CEO compensation packages. The only reason it happened here is due to Tesla’s extraordinarily poor corporate governance,” she told Observer. Lipton added that even though McCormick opens her ruling by asking if the world’s wealthiest person was overpaid, Musk’s net worth was not a factor in the court’s decision and pertained only to the lack of proper independent oversight over the process that allowed the compensation package to exist.
The law typically looks at whether a board member is “beholden” to the CEO to assess if they are independent, said Lipton. This was likely an issue leading to McCormick’s decision because Tesla’s board included close Musk allies, including his brother and long-time business partner Kimbal Musk.
The University of Delaware’s Klein said a similar-sized compensation package for Musk could hypothetically still happen if Tesla adjusts its board and compensation committee to show stronger corporate governance. Alternatively, Tesla could try to recreate the same pay package after incorporating in Texas and see if a new lawsuit arises, he said.