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Did a Recent Elon Musk Court Ruling Kill Delaware for Business Incorporations?

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Delaware has long been known as the capital of business formations.  Almost 70% of Fortune 500 companies have their domicile in Delaware.  However, a recent court Case in the Delaware Chancery Court involving Elon Musk and Tesla may unseat Delaware as the King of business formations.

The Pay Package Case Against Elon Musk

A Delaware Court ruled on January 30th that Elon Musk is not entitled to the momentous compensation package awarded by Tesla’s board of directors back in 2018 which is potentially worth more than $55 billion. The ruling by Chancellor Kathaleen St. Jude McCormick comes more than five years after a shareholder lawsuit directed at Tesla CEO Musk and directors of the company. They were accused of breaching their duties by agreeing to a pay package with Musk. Judge Kathaleen McCormick on Tuesday ruled that Tesla fell short of even that standard and ordered Musk’s 2018 compensation deal be rescinded.

The plaintiff in the Delaware case is a Tesla shareholder who owned just nine Tesla shares.  The Plaintiff argued that the Tesla board failed to exercise independence from Musk when it created the 2018 pay package. In her ruling, the judge said the process the Tesla Board undertook that led to Musk’s plan was “deeply flawed” and that he had “extensive ties” with the people involved.  The ruling, which can be appealed, quashes the largest pay package in corporate America. The judge found the share-based compensation was negotiated by directors who appeared bound to Musk.

Tesla’s 10-year pay agreement with Musk reached in 2018 would be worth around $51 billion at Tuesday’s closing price for Tesla stock, accounting for the cost to Musk to exercise the options.  However, at the time the package was negotiated, the compensation package was valued at just over $2 billion.  Additionally, as part of the deal, Musk agreed to take no financial compensation or bonus payment.  Moreover, the share-based compensation package was based on highly lofty stock and revenue thresholds that most commentators thought were highly unlikely to be met.  In sum, Musk took a huge gamble with the way his share compensation package was structured.  If Tesla did not reach the lofty share and financial conditions that Musk agreed to, he would not be entitled to any compensation under this agreement.

The Tesla board contended during the trial that the company was paying to ensure one of the world’s most successful entrepreneurs continued to dedicate his attention to the business.  While the Plaintiff argued that the Tesla board never told shareholders the financial goals were easier to achieve than the company. The Plaintiff also argued that the board had a duty to offer a smaller pay package or look for another CEO.

Even though the value of Tesla increased from $50 billion at the time of the share grant to around $1 trillion and the share price increased more than ten times, the Court ruled against Musk and the Board.

Related: Business Retirement Plans for Small Businesses

The Delaware Incorporation Advantage

Why do so many Fortune 500 companies elect to form their business in Delaware?  In addition, hundreds of thousands of new businesses elect to establish their companies in Delaware every year.  There are several reasons why Delaware has been known as the king of all states for entity formation purposes.  

Delaware Court of Chancery

The Delaware Court of Chancery is probably the most important reason why large corporations choose Delaware as their state of formation.  When one forms a company in Delaware, Delaware is the state of domicile of the company.  Hence, the rules and regulations the company obeys are the Delaware corporate laws as applied by the Delaware Court of Chancery. The Court of Chancery is one of the country’s oldest law courts and they only handle corporation cases. In addition, Delaware is well-known for its fair and flexible corporate laws and its case law The judges sitting on the Court of Chancery are experienced in corporate formalities and are perceived as corporate law experts.  Accordingly, it is believed that decisions handed down by the Chancery Court are generally more predictable than those in other states.  Corporations appreciate predictability when it comes to business litigation especially when it comes down to complex commercial law.  Likewise, because Delaware is such a popular state for incorporation, corporate attorneys are generally well acquainted with Delaware’s corporate law.

Delaware Corporate Tax Benefits

Although other states are attracting founders who are incorporating with no corporate taxes, such as South Dakota, Delaware still has very business-friendly tax law. Rather than taxing income in the state where the business occurred, the “Delaware loophole” makes it possible for companies to declare certain types of revenue in Delaware. In addition, Delaware does not impose a corporate tax, impose a tax on royalty payments, and does not tax stock shares owned by shareholders outside of Delaware. 

Related: Tax Deferral vs Tax Free

Flexible Corporate Statuses

The legal framework for corporations in Delaware is flexible and perceived as pro-business. Shareholders, officers, and directors don’t have to live in Delaware. The state will also allow just one person to be the director, shareholder, and officer of a corporation.

Investor Favor Delaware

For start-ups that foresee the need to raise capital from outside investors, venture capitalists, private equity, and investment banks often favor investing in companies that are incorporated in Delaware.

The Impact of the Tesla Case on Delaware

The significant impact of the McCormick ruling in the Tesla case is that the ruling went against the board and shareholder vote.  The Musk 2018 share pay package was approved by the board and approved by almost 70% of all Tesla shareholders, excluding Elon Musk and his brother. What was so shocking about the ruling, is that the court ignored the vote of a significant number of shareholders who approved the pay package and ruled it invalid almost six years after it was agreed to.  Since the ruling was handed down, Musk has tweeted that he is considering changing Tesla’s state of incorporation from Delaware to Texas.  Will other companies consider a similar path?  It is a possibility that companies begin losing faith in the perception that Delaware is pro-business, its corporate rules are flexible, and because of the Court of Chancery.  However, if the Court of Chancery becomes known as unpredictable and not in line with the interests of Delaware businesses and their board of directors, a changing of the guard could be on the horizon when it comes to the go-to state for corporate incorporations.

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