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Entire Fairness - A Unitary Test under which Fair Price is Paramount

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On June 6, 2023 the Delaware Supreme Court affirmed the Chancery Court’s ruling in In re Tesla Motors, Inc. Stockholder Litigation (“In re Tesla”), denying Tesla, Inc. (“Tesla”) stockholders’ claims for $13 billion in damages from Elon Musk, the CEO of Tesla. Even though the Court expressed some dissatisfaction with the lower court’s decision, it affirmed the denial of damages, holding that the entire fairness standard of review was properly applied and reiterated that, while such test is unitary, the paramount consideration is whether the price was fair.

In In re Tesla, the stockholders’ claims related to Tesla’s acquisition of SolarCity Corporation (“SolarCity”) in 2016. At the time of the acquisition, in addition to being the CEO of Tesla, Musk owned approximately 22% of the stock of SolarCity, Musk’s brother sat on the board of Tesla, Musk was the chairman of SolarCity’s board, and Musk’s cousin served as SolarCity’s chief executive officer. As mentioned in our Client Alert of September 8, 2022 (available here), the Chancery Court’s decision in In re Tesla marked a rare instance where a defense verdict was obtained in the context of a conflicted transaction subject to the “entire fairness” standard of review. Despite finding that “the process employed by the Tesla board to negotiate and ultimately recommend the acquisition was far from perfect,” the Chancery Court’s conclusion was that the transaction was “entirely fair in the truest sense of the word” and that the positive elements of the transaction process, in combination with a fair price, supported a finding in favor of defendant Musk.

On appeal, the Tesla stockholders challenged this finding on the basis that the Chancery Court had put too much emphasis on the price that Tesla had paid for SolarCity, and not enough on the deal process. The stockholders cited issues in deal timing, disclosure in the context of the stockholder vote, and, most notably, that Tesla failed to appoint an independent committee to negotiate the acquisition. Further, the stockholders argued that the Chancery Court’s fair price analysis was flawed in that it relied on SolarCity’s stock price on June 21, 2016, a price they contend wasn’t reflective of facts about SolarCity that weren’t public at the time.

In support of the stockholders’ arguments, a group of 15 law professors filed an amicus brief claiming that the trial court had given more weight to the price paid to the stockholders than it should have. Like the stockholders, amici argued that although stock price should be an element of determining whether a deal is fair or not, the facts of this case show that the Chancery Court should have given more weight to the process.

The Delaware Supreme Court was unconvinced by the appellants’ and amici arguments. In its review of the lower court’s application of the entire fairness standard, the Delaware Supreme Court reiterated that the test is unitary in its consideration of price and process (not bifurcated), recognized and accepted the lower court’s emphasis on fair price in this case, and held that “we have long recognized that, sometimes, a fair price is the most important showing.” The Court also held that while fair dealing may demonstrate fair price, “the paramount consideration, however, is whether the price was a fair one.” Ultimately, while the Delaware Supreme Court expressed some dissatisfaction with the lower court’s presentation of its findings and agreed that the reliance on SolarCity’s June 21, 2016 stock price was unsupported, it found no reversible error and affirmed the lower court’s judgment. Justice Valihura further wrote “[t]here can be no dispute that the trial court weighed both fair dealing and fair price and found that Musk proved his case. The record demonstrates that the negotiations were conducted at arm’s-length, in good faith, with the advice of independent financial and legal advisors, led by an indisputably independent director, and, thus, consisted a fair process that led to a fair price.”

In addition to the arguments regarding the weighting of price and process, appellant stockholders and amici warned that affirming the Chancery Court’s findings might disincentivize boards from complying the important procedural mechanisms previously espoused by the court, particularly the use of an independent committee in negotiating conflicted transactions. The Delaware Supreme Court addressed this question head-on in its opinion, noting that:

  1. prior Delaware Supreme Court decisions have established “best practices” for conflicted transactions that, if followed, avoid the transaction being subject to entire fairness;
  2. notwithstanding these “best practices”, there may be reasons why a board may decide not to employ them; and
  3. nothing in Delaware law requires a board to form a special committee or, in most cases, follow such best practices.

It was, therefore, inappropriate, in the Court’s view, to consider the absence of a special committee, one of the most commonly utilized “best practices,” as a fact that would in itself impose liability as a matter of law. Instead, the consequence of an absence of one or more of the best practices is the failure to avoid the entire fairness review, “an expensive, risky, and ‘heavy lift’ in the litigation arena.”

This decision does not significantly change the process that boards, controlling stockholders and companies should follow when considering potentially conflicted transactions, but reiterates that establishing fair price is of critical importance when entire fairness applies.

To reduce the risk of facing litigation and the applicability of, or burden of proving, entire fairness, the following “best practices” should be observed:

  • Empower an independent, inquisitive and diligent special committee.
  • Authorize and encourage the special committee to select high-quality legal and financial advisors.
  • Obtain unaffiliated stockholder approval.
  • Avoid interference by the conflicted controller.
  • Engage in hard-nosed negotiations and get meaningful concessions.
  • Conduct robust due diligence, particularly in support of assessing value.
  • Carefully document the special committee’s process.
  • Consider transaction timing, both in terms of providing sufficient time to follow an appropriate process and as a matter of corporate strategy.

In sum, although the Delaware Supreme Court’s affirmation may be read as lenient in the context of applying the entire fairness standard of review in conflicted transactions, boards, management teams and other corporate actors would be well-advised to continue to prioritize a thoughtful and well-designed transaction process that seeks to meet the Court’s stated “best practices.” Doing so can avoid the transaction from becoming subject to the entire fairness standard of review or, in the alternative, provides robust support in the record to prevail on potential future stockholder claims.

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