Tesla Comp Case Highlights Increased Board Scrutiny

Recent Delaware court decisions indicate that board votes on CEO compensation are being held to a different standard than other governance calls.

When Tesla’s board voted to award an incentive-based compensation package worth $55.8 billion to CEO Elon Musk, a shareholder brought suit, alleging that approval of that jaw-dropping number amounted to a breach of fiduciary duties. The Delaware Chancery Court denied the directors’ motion to dismiss, holding that the board’s decision was subject to entire fairness review, despite the fact that it was approved by an independent board committee and ratified by disinterested shareholders. (Musk and his brother, the controlling shareholders, recused themselves.)

The Tesla case is something of an anomaly because the CEO is the controlling shareholder. On its own, it would not be cause for concern, says attorney Bob Profusek, who chairs Jones Day’s global M&A practice and co-authored a report on the subject. “It’s really in the context of a series of decisions in the last couple of years indicating that the Delaware courts—which are the most influential in the country on governance issues, of course—seem to be trying too hard to identify problems where none really exists.”

If it is indeed the board’s decision to decide compensation matters, and not shareholders’, then that decision should be entitled to deference, says Profusek, who also sits on three boards. He adds that because of the business judgment rule, which says that the courts should defer to director decision-making in most circumstances, “unless it’s really way out of bounds, the courts typically leave it alone.”

But the winds that began shifting during the financial crisis have continued to blow, carrying the notion that executive compensation drove the practices that resulted in the collapse of Lehman Brothers, AIG and others. Meanwhile, at the same time, the U.S. economy has shifted from largely manufacturing and product sales to service  and tech—and people in those industries are making a lot more money.

The courts may not be immune to shifting public sentiment. “Courts are comprised of human beings. They look around and they recognize that income disparity is a major issue in our country, and will be at least one of the major issues in the Presidential campaign next year—and it influences their behaviors,” says Profusek. “In my judgment as a lawyer, they’ve started to nitpick board decisions about compensation in a way that is inconsistent with the general division of responsibility among boards, shareholders and management.” As a result, he adds, “common sense is sometimes left at the altar because, all of a sudden, we’re focusing on compensation in a way that’s different than the way we focus on other decisions the board makes.”

So what can a board do to ensure it does not invite heightened scrutiny on executive and director pay decisions? “Don’t let any compensation decision be routinized,” says Profusek. Even the best boards, for-profit or not-for-profit, can fall into the trap of passivity or going through the motions; decisions are not documented as well as they could be, minutes fail to be updated, record-keeping is inconsistent.

That’s where the trouble starts, Profusek says. “Don’t go on automatic pilot with any of this stuff—that would be my advice.”