The largest compensation package in history was recently voided by a Delaware Court of Chancery judge, sending a message to corporate board members that it is their fiduciary duty to negotiate in good faith on behalf of investors. A key question for board compensation committees to ask, “Is it necessary to overpay to retain a company CEO?”
Judge Kathaleen McCormick determined that Tesla CEO Elon Musk’s 2018 10-year pay agreement that would have awarded him 12 tranches of Tesla stock options that would vest if the company’s market capitalization grew by $50 billion and revenue targets were reached was “unfair” to investors. The company’s market cap has grown from $50 billion in 2018 to more than $586 billion today (it briefly topped $1 trillion in 2021), which would mean Musk’s options would have vested.
However, the lawsuit challenging the compensation plan filed by Tesla shareholder Richard Tornetta argued that because the Tesla board was “controlled” by Musk, they weren’t upfront with investors about how easily it would be for Musk to meet the plan’s targets and made no effort to find a less expensive way to retain the CEO. None of Musk’s peers were being paid anywhere near the amount his compensation plan offered, so why offer such an historic amount? According to a report from CNBC, Judge McCormick wrote in her decision, “Put simply, neither the Compensation Committee nor the Board acted in the best interests of the Company when negotiating Musk’s compensation plan. In fact, there is barely any evidence of negotiations at all… Rather than negotiate against Musk with the mindset of a third party, the Compensation Committee worked alongside him, almost as an advisory body.”
Compensation plans have gotten increased scrutiny from investors in recent years and the ruling in this case will bring even more attention to how boards compensate key executives. Among the areas that will be scrutinized going forward:
Board independence. Since the board negotiates and approves the CEO’s compensation package it is imperative that members of the board show no favoritism toward the CEO. Testimony from the trial alleged that the Tesla board had several directors who reportedly had personal relationships with or were partial to CEO Musk. When compensation packages are presented this year, boards can expect that shareholders are going to consider the independence of the directors who voted for the plan. Even the appearance of directors being heavily influenced by the CEO may impact whether investors approve or reject compensation plans put up for vote. Boards should be mindful that their members may need to be more independent than has been accepted in the past.
Proposed compensation levels. Any time a company proposes an outsized compensation package for its CEO, it will likely draw major scrutiny. Therefore, compensation committees should consider why they would be willing to pay more for their CEO than what other similar companies are paying. Boards may need to pay attention to the compensation levels of key executives at peer companies in their industry. Additionally, investors will be examining more closely the type of goals and targets in the plan as well as the rewards for reaching those goals. According to a report from Reuters, one of the issues the plaintiff argued against Elon Musk’s compensation package was that company projections showed that the plan’s goals “were easier to achieve than the company was acknowledging.” Attempting to award high compensation for easily achieved outcomes could produce backlash from investors.
Proof of fairness. With this ruling, corporate boards should be prepared to provide proof that their compensation packages are fair to investors. If investors sue to revoke a compensation plan, the burden of proving the plan is legal, fair and in the best interest of investors will fall on the board. Compensation committees may want to consider developing a strategy for defending their compensation plan goals, targets and levels of renumeration as they create their compensation plans in the future.