All Roads Lead To Fair Price: The Lesson of Tesla

Block & Leviton's Joel Fleming sums up this important decision

In late April, the Delaware Court of Chancery issued its highly anticipated post-trial ruling in the In re Tesla Motors, Inc. Stockholders’ Litigation, a derivative action brought by Tesla stockholders against Elon Musk, Tesla’s CEO and largest stockholder. (The Tesla plaintiffs had reached partial pre-trial settlements with other defendants for $60 million. Musk was the sole remaining defendant at trial.) In a decision that came as a surprise to many informed observers, the Court found in favor of Musk on all counts.

The Tesla action challenged Tesla’s 2016 acquisition of SolarCity Corporation, a company founded by Musk’s cousins and of which Musk was the largest individual stockholder. Plaintiffs alleged that Musk was Tesla’s controlling stockholder and thus required to prove that both the process and price of the Tesla-SolarCity transaction was “entirely fair” to Tesla. Plaintiffs argued that the transaction was not fair and that Tesla had, in fact, overpaid by roughly $2.6 billion—the difference between the value of the Tesla shares issued to SolarCity stockholders as merger consideration and the true value of SolarCity’s common stock (which the plaintiffs alleged to be $0).

Many commentators had expected the Tesla case to turn on the question of whether Musk could be considered a controlling stockholder under Delaware law, despite only owning 22% of Tesla’s common stock at the time the transaction was signed. But in its 131-page opinion, the Court declined to resolve that question. It also declined to determine whether the negotiation process was entirely fair. Instead, the Court held that “while there are necessary stops along the way, all roads in the realm of entire fairness ultimately lead to fair price” and found that it was unnecessary to decide anything else because Musk had “proved that the price Tesla paid for SolarCity was fair—and a patently fair price ultimately carries the day.”

As a result—contrary to expectations—Tesla is unlikely to be seen a landmark decision with significant doctrinal consequences for future cases. The ruling is heavily fact-bound and specific to the unique facts of this case. It should not have significant influence on the development of Delaware law or the outcome of future cases.

But there is still a significant practical lesson to be drawn for investors and their lawyers. The Tesla Court gave six reasons for its conclusion that the price was patently fair: “(1) SolarCity was far from insolvent … (2) discounted cash flow (‘DCF’) analyses are not helpful here; (3) market evidence supports the price Tesla paid; (4) SolarCity’s current and future cash flows support a finding of fair price; (5) [Tesla’s financial advisor,] Evercore’s fairness opinion and valuation work accurately captured SolarCity’s value; and (6) the fair price analysis must account for the substantial synergies flowing to Tesla from the Acquisition.”

There is ample reason to disagree with the Court on many of these points. Points (2) and (4) directly contradict each other because a discounted cash flow analysis is just a way of valuing future cash flows by applying a discount rate to calculate the present value of those cash flows. If a DCF was “not helpful,” then SolarCity’s “future cash flows” cannot “support a finding of fair price.”

Point (3)—“market evidence” (i.e., SolarCity’s pre-announcement trading price and the fact that Tesla stockholders voted to approve the transaction)—is similarly unconvincing. It ignores that plaintiffs had identified significant material facts that were not known to the market. The Court brushed that problem aside—providing just a cursory analysis of only one of several disclosure issues raised by the plaintiffs.

The most significant problem for plaintiffs, however—which will undoubtedly be the focus of any appeal—is Point (1). As the Court explained, “Plaintiffs placed their valuation case entirely in [one expert’s] hands, and [that expert], in turn, relied exclusively on a single valuation theory: insolvency. In other words, by Plaintiffs’ lights, SolarCity was ‘worthless’ at the time of the Acquisition.” This was a decidedly aggressive position for plaintiffs to take regarding a company that had a market capitalization of approximately $2.1 billion at the time the transaction was announced.

That aggression backfired. The Court wrote that, “as is often the case when one swings for the fences, [plaintiffs’ expert] failed to make contact altogether.” The Court concluded that plaintiffs’ expert’s “conclusion that [SolarCity was] worth [] nothing is incredible on its face” and that “[b]y relying so heavily on [that expert] and his ‘incredible’ conclusion,” in the eyes of [the Court], Plaintiffs undermined the credibility of their fair price case completely.”

Investors should take careful heed of this warning. In preparing a damages analysis, plaintiffs will always face a strong temptation to push the envelope and argue for the largest damages possible. The conventional wisdom is that arguing for the largest damages possible is a good idea because it will make a settlement look more reasonable and encourage the ultimate fact-finder (whether a judge or jury) to “split the baby” and award damages in between $0 and plaintiffs’ inflated-to-the-maximum number.

Tesla suggests that that conventional wisdom may be misplaced. While every case is different, investors and their counsel should always consider whether the wiser course is to seek a more modest damages award that can be easily supported by the evidence and attack the credibility of defendants who argue for a zero damages award, even if a fiduciary breach is found.

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June 22, 2022

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