Much ink will be spilled in the circles of corporate law about Chancellor McCormick's blockbuster opinion in Tornetta v. Musk, C.A. No. 2018-0408-KSJM (Del. Ch. Jan. 31, 2023), in which the Court invalidated a CEO's executive compensation package worth $55 billion. A full discussion of the over-200-page opinion is beyond the scope of this blog, but one key takeaway for our readers may be this simple maxim: to preserve judicial deference to a corporate board's independent business judgment, corporate directors need to actually exercise their independent business judgment.
Corporate directors are presumed to be independent, and therefore ordinarily a decision on how to compensate the CEO or other corporate officers is a matter for their business judgment which usually will not be second-guessed by a reviewing court. When, however, directors act on a matter for which they either have a conflicting interest, or for which they are facially disinterested but cannot or did not act independently, the courts of Delaware review the transaction under the "entire fairness" standard. Under "entire fairness," both the transaction process and the transaction terms are examined by the court, holistically and searchingly, for their intrinsic fairness to the entity and the stockholders. Before reaching the question of whether the transaction was entirely fair, the Chancellor therefore addressed the question of whether entire fairness review was appropriate in the first place.
At the time the compensation package was proposed and negotiated, the CEO owned slightly more than one-fifth of the company's equity and voting power. That made him an extremely influential stockholder, but not a completely dominant one — at least, not on paper. He lacked the power to elect or remove corporate directors unilaterally, for example.
Instead, what was decisive for the Chancellor was the behavior of other corporate directors and officers in the compensation transaction itself, all of whom she found to have treated the CEO as the key decision-maker. The CEO proposed the structure and size of his compensation package, and the other board members and corporate officers, rather than engage in adversarial negotiation, or consider alternatives, engaged in a "cooperative and collaborative process" to make the CEO's proposal a reality. As a result, instead of the Board of Directors negotiating with the CEO at arm's length on the nature and dimensions of his compensation package, she found the CEO was essentially deciding on his own compensation, i.e. acting as a self-interested controller, with the attendant application of entire fairness.
Examining the process of the transaction is, as noted above, a part of entire fairness review. But Tornetta shows that a sufficiently poor process can itself be a major factor prompting the Court to conduct entire fairness review in the first place. That is, if directors conduct themselves with a 'controlled mindset,' that appearance can itself be evidence that facially-disinterested directors are beholden to the one to whom they are deferring, and vitiate the protections of the business judgment rule.
Delaware courts give great deference to corporate directors and other fiduciaries when they exercise their own independent judgment. But, they place that deference at risk if they surrender that judgment to someone else, like a "superstar CEO." Thus it remains critical that corporate fiduciaries remember to apply their own judgment to decide what is in the company's best interests, and to articulate their reasons for why they are thinking and acting the way they are. And, of course, as has been mentioned on this blog before, ideally they should remember to accurately and timely document their actions and reasoning in the minutes.
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