Harvard Law School: Did Elon Musk Have "Domination" Over His Board When Tesla Acquired Solar City?

A lawsuit alleging that Elon Musk had full control of his board and a conflict of interest by acquiring SolarCity - and that the company was negligent in not forming a special committee to independently assess the idea of the merger and its impact on shareholders - may have just gotten another vote of support, this time the fine folks at the Harvard Law School Forum on Corporate Governance.

It was reported on a couple weeks ago that a shareholder lawsuit against Elon Musk for his acquisition of the debt laden SolarCity was going to be allowed to proceed in Delaware. This lawsuit represents just one of Tesla's many ongoing regulatory and legal concerns at the moment:

The lawsuit alleged the board of Tesla breached its duties to shareholders by approving the SolarCity deal.

Tesla bought solar panel installer SolarCity for $2.6 billion in an all-stock deal in 2016. Musk was then biggest shareholder in both Tesla and SolarCity, and his SolarCity shares were converted to $500 million of Tesla shares.

It is “conceivable that Musk, as a controlling stockholder, controlled the Tesla board” during the SolarCity deal, the judge said.

Part of making the case for the plaintiffs would be establishing that the acquisition was:

1. Not in the best interest of shareholders

2. Fully decided upon and implemented by Elon Musk

3. A result of Musk having control over the Board of Directors

4. Not looked at critically for conflicts of interest and impact to Tesla shareholders

On Monday of this week, the Harvard Law School Forum on Corporate Governance published a blog outlining the background of the transaction and - in keeping with the court's decision - its reasoning for why Elon Musk may have had full control over the board at the time the Solar City deal was consummated. If its conclusions are echoed by the court that is adjudicating this case, it could lead to further unfavorable litigation for Musk/Tesla that ultimately goes down a road that could lead to a significant settlement or even trial. The Harvard blog provided the following background:

Recently in In re Tesla Motors, Inc. Stockholder Litigation, the Delaware Court of Chancery (in an opinion by Vice Chancellor Slights) declined to grant defendants’ motion to dismiss because the court found it reasonably conceivable that Elon Musk, a 22.1% stockholder of Tesla Motors, Inc., was a controlling stockholder and therefore Tesla’s 2016 acquisition of SolarCity Corporation (of which Musk was the largest stockholder and founder) would be subject to a stringent entire fairness review. In this regard, it is rare for Delaware courts to find that a stockholder with such “relatively low” ownership levels is a controller. They have done so only, as was the case here, where there is other evidence that the stockholder exercised “actual domination and control over … [the] directors” and wielded more power than may be evidenced by the stockholder’s minority holdings. The court’s conclusion that Musk was a controller meant that stockholder approval of the acquisition did not ratify the transaction and invoke business judgment review because Corwin v. KKR Financial Holdings LLCdoes not apply to controller transactions.

Elon Musk, a 22.1% stockholder of Tesla, was the company’s largest stockholder and also its chairman of the board, CEO and Chief Product Architect. Musk also co-founded SolarCity Corporation and was its largest stockholder and the chairman of its board. In 2016, Tesla acquired SolarCity in a stock-for-stock transaction. Musk had proposed the transaction to the Tesla board on several occasions and the well-pled facts suggested that such an acquisition was in Musk’s long-term plan for Tesla. The Tesla board did not form a special committee to consider the potential acquisition, despite “obvious conflicts” of the directors, including their personal and business relationships with Musk and ownership of SolarCity stock. The court also noted that Tesla’s debt load would nearly double after the acquisition due to the fact that SolarCity was in the midst of a liquidity crisis. Yet despite all of these and other issues, Tesla stockholders approved the acquisition in a vote that excluded certain interested Tesla stockholders who were also directors or executive officers of SolarCity. Plaintiffs, Tesla stockholders, brought suit challenging the transaction, and the defendants moved to dismiss.

The blog then lists its takeaways from the Delaware litigation:

In Tesla, the court agreed with the plaintiffs that the well-pled facts presented such unique circumstances, which facts combined to make it reasonably conceivable that Musk controlled Tesla, including that:

  • Musk held what could be the equivalent of majority voting control because he had the ability to rally other stockholders to bridge the gap between his 22.1% ownership stake and majority control. This alone would not be enough to make him a controller, but the plaintiffs also pled that Musk demonstrated a willingness to use such power to oust senior management when he was displeased, having replaced the former CEO and appointing himself to the position.
  • Musk exercised control over Tesla’s board as the company’s visionary, CEO and chairman of the board. When considering the transaction, the board was well aware of Musk’s “singularly important role in sustaining Tesla in hard times and providing the vision for the Company’s success.” There were no steps taken to separate him from the board’s consideration of the SolarCity acquisition, such as through the formation of a special committee, and he even led the board’s discussions regarding the acquisition and engaged the board’s advisors.
  • Musk had strong personal and business connections with the other directors, making a majority of them interested in the transaction. According to plaintiffs, the fact that Tesla paid approximately $2.6 billion in its own stock to acquire SolarCity, a severely distressed company on the brink of bankruptcy, suggested that no fiduciary acting in good faith could have approved those terms, and further revealed that the board was dominated by Musk when voting to approve the acquisition.
  • Musk and Tesla repeatedly acknowledged Musk’s influence over the company in public filings, noting that he “contributed significantly and actively” to the company by recruiting talent, contributed to product engineering and design, raised capital and public awareness of the company, and “spen[t] significant time with Tesla and [was] highly active in [Tesla’s] management.” The company also publicly stated that a loss of Musk’s services would disrupt and have a negative impact on its business, and that the concentration of ownership among the company’s executive officers and directors may prevent new investors from influencing significant corporate decisions. For his part, Musk publicly stated that Tesla, SolarCity and SpaceX (another company founded by Musk) form a “pyramid” on top of which he sits, and has referred to Tesla as “his company.”

Based on the foregoing, although decisions finding minority shareholders to be controllers continue to be relatively rare, companies entering transactions with significant, influential stockholders may not be able to rely on a stockholder vote (even where informed and involving only disinterested stockholders) to attain dismissal of transaction-related litigation and to insulate the action from entire fairness review, especially where any facts support outsized control over the management and direction of the company by the stockholder. Boards in such situations may need to consider the protections mandated by Delaware courts in controlling stockholder transactions to invoke business judgment protection (e.g., conditioning the transaction ab initio upon both (i) the approval of an independent, adequately empowered special committee that fulfills its duty of care and (ii) the uncoerced, informed vote of a majority of the minority stockholders).

So the lawsuit will proceed and it looks as though it is going to be one more significant "fly in the ointment" for Tesla, which has experienced its fair number of bumps in the road this year, so far, on its way to belatedly trying to figure out how to be a car company.

The tally of bad press, lawsuits and investigations of recent relating to Tesla continues to pile up.

  1. NTSB investigation that put the company at a public feud with the NTSB
  2. An initial workplace safety investigation by the state of California
  3. second reported workplace safety investigation, reported on Friday
  4. securities fraud class action lawsuit against Musk claiming he knew he was going to miss Model 3 targets for 2017
  5. This contract worker lawsuit
  6. CNBC article detailing poor vetting of suppliers, leading to a pile up of malfunctioned parts
  7. Reports of the company cutting corners as it relates to their pre-owned vehicles
  8. Reveal article alleging the company is underreporting its safety incidents at its Fremont factory
  9. Recent massive recall of 125k Model S sedans
  10. A scathing review of the company's possible future (or lack thereof) in Automotive News by Keith Crain
  11. This Harvard Law School blog that seems to side with plaintiffs who have brought suit against Tesla for its acquisition of Solar City

Despite this, and as a reminder, we've been promised by Elon himself that Tesla:

  1. Will be cash flow positive in Q3 and Q4 of this year
  2. Will not need to do another capital raise in 2018
  3. Will produce 6,000 Model 3's per week, starting this summer

As more developments take place with this lawsuit and Tesla, we will stay on top of them.