SpaceX Leaves Delaware; Should Others Follow?

Overview

On January 30, 2024, the Delaware Chancery Court voided Elon Musk’s $55.8 billion pay package as CEO of Tesla, ruling that the process leading to the approval of Musk’s Tesla compensation plan was “deeply flawed” and unfair to Tesla’s shareholders. In response, Musk expressed public criticism of the Court’s decision, including posting on X (formerly Twitter) that entrepreneurs and founders should “never incorporate your company in the state of Delaware.” Ultimately, in response to the Tesla ruling, Musk filed to transfer SpaceX’s state of incorporation from Delaware to Texas and indicated that Tesla would hold a shareholder vote to do the same.

Delaware has long been the preferred state of incorporation for many U.S. companies, with nearly 70% of Fortune 500 companies calling it home. However, in response to the Court’s ruling and Musk’s subsequent statements and actions, business owners and founders are asking whether they should stick with Delaware as the state of incorporation for their businesses. This blog post aims to briefly discuss the historical benefits of incorporating in Delaware and touches on whether the Musk decision could be signaling a shift in Delaware’s corporate jurisprudence.    

Incorporating in Delaware vs. Other States

In 2009 and 2012, Tesla and Musk agreed to stock option grants tied to operational and financial milestones. In 2018, a new compensation plan for Musk was approved by both the board and the disinterested shareholders of Tesla. The plan was worth up to $55.8 billion, but for Musk to actually receive that amount of compensation, Tesla would have to achieve very ambitious market capitalization and performance targets. Tesla did, in fact, hit all of the targets, and thus, Musk received $55.8 billion in compensation.

In 2018, certain Tesla shareholders brought a derivative lawsuit challenging the compensation plan, alleging that Tesla’s directors had breached their fiduciary duties by awarding Musk such a massive compensation package. In a lengthy decision, the Delaware Court of Chancery ultimately sided with the plaintiff shareholders. The decision sparked outrage from Musk, who publicly stated that he would hold a vote to move Tesla’s state of incorporation from Delaware to Texas.

The court determined that with respect to the compensation grant, Musk controlled Tesla, and the Board’s approval was, therefore, a “conflicted-controller transaction,” which triggered the application of the “entire fairness” standard rather than the “business judgment rule.” This shifted the burden of proof as to the fairness of the package from the plaintiffs to Musk. Musk had long-standing friendships and business relationships with the outside directors, the directors had obtained wealth through their ownership of shares in Tesla and other business ventures led by Musk, and this information was not disclosed to the shareholders in connection with their approval of the compensation package. Despite arguments that the plan incentivized Tesla’s growth, the Court deemed it unnecessary, as Musk’s existing stake compensated him adequately. Finding that Tesla failed to prove the compensation grant was entirely fair due both to conflicts in its negotiation and that the package was inappropriate for achieving its stated goal, the court ordered its rescission.

Based on the court’s decision and Musk’s public statements, many other companies have asked if they should move their state of incorporation from Delaware. Underlying this question is the concern that Delaware courts are now activist and no longer business-friendly. How could a court overturn a compensation plan with such ambitious goals, even after it was approved by the shareholders? Should companies relocate from Delaware?

Our view is that the court reasonably applied Delaware law, which resulted in the application of the “entire fairness” standard. Although shareholder approval of the compensation plan was obtained, all of the relevant disclosures to the shareholders were not made, and thus the approval was ineffective. Historically, there have been many benefits to incorporating a company in Delaware versus doing so in the company’s home state or another state perceived to be business-friendly, and we believe these reasons continue to exist. The typical business-friendly advantages of incorporating in Delaware include: (i) a well-established legal framework with a robust body of corporate law; (ii) a specialized business court (the Court of Chancery) known for its expertise in resolving corporate disputes efficiently; (iii) favorable tax regulations; (iv) easily accessible online and filing services; and (v) business-friendly statutes. While certain of these advantages exist to varying degrees in other states, such as Nevada or Wyoming, and it often makes sense to incorporate them in your home state, it is still the case that no other state has the historical depth of case law and sophisticated jurisprudence as Delaware.

In conclusion, we are not persuaded by those stating that the Delaware courts are now activist courts and suggesting that companies incorporate in other states. We believe the Musk decision was a reasonable application of the law in Delaware, and that Delaware remains the preeminent state for incorporating business entities. However, the case is also a good reminder that board independence and disclosure of all relevant information when seeking shareholder approval is critical.