More Elon Musk Litigation – purchase of SolarCity in 2016

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On November 21, 2016, Tesla purchased 100% of the outstanding shares of SolarCity Corp. Tesla paid for the shares with Tesla stock, giving SolarCity shareholders Tesla stock valued at about $2.6 billion. A few Tesla shareholders sued the seven-person Tesla Board of Directors (“BOD”) for breach of their fiduciary duties. The shareholders argued in part that the shares of SolarCity were worthless when acquired, or at least worth a lot less than the amount paid.

At first blush, the business judgment rule (“BJR”) would make the court’s task easy. The directors win if they did their due diligence, i.e., made an informed decision, and there was no conflict, fraud, waste or bad faith. Suffice it to say they did a lot of due diligence.

But let’s dig a little deeper into the facts. Elon Musk was the largest shareholder of both Tesla and SolarCity owning about 22% of the publicly traded stock of each. He was also Chairman of the Board of SolarCity which he founded with his two cousins, Peter and Lyndon Rive. Elon, his brother Kimbal Musk, and one other person, Antonio Gracias, sat on both boards. Three other Tesla directors owned some SolarCity stock directly or indirectly. Hmm? Conflicts maybe? Loyalty issues?

So a huge portion of the amount paid for SolarCity went into Elon’s pocket. Other amounts went to his brother and four of the other Tesla directors. Only one Tesla director, Robyn Denholm, was completely disinterested financially.

But digging a little deeper still, this time focusing on the process of getting to the price Tesla paid, the Tesla BOD did not form a committee and did not exclude Elon from the negotiations. But it did hire an expert to opine on the valuation. Further, when it reached the purchase price, it submitted the issue to the disinterested shareholders. The disinterested shareholders approved the deal which closed the next day.

The unhappy shareholders, i.e., the plaintiffs here, argued that Elon dominated the BOD and since their directors had their own conflicts anyway (being shareholders of SolarCity), the BJR did not apply and therefore the matter must go to trial to determine if they used appropriate care, i.e., good faith business judgment and care of a reasonably prudent person under similar circumstances. They argued further that since six of the directors were putting money in their own pockets, the court must have a trial to determine if the price paid was fair to Tesla. Lastly, they argued that Elon, as a controlling shareholder, dominated the disinterested shareholders so the vote of those shareholders should carry no weight or any favorable presumption.

The crux of the matter then is whether the transaction was fair to Tesla and its shareholders. The Delaware court set the issue of care to the side at the outset. If the transaction was fair to the now-diluted Tesla shareholders, there are no damages and care would not be an issue. As to fairness, the court noted that the analysis is two-fold. It observed:

“The concept of fairness has two basic aspects: fair dealing and fair price.‘  Fair dealing (or fair process) ‘“’embraces questions of when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were obtained.’  Fair price ‘relates to the economic and financial considerations of the proposed merger, including all relevant factors: assets, market value, earnings, future prospects, and any other elements that affect the intrinsic or inherent value of a company’s stock.’” The burden of persuasion lies generally with the defendants.

The court conducted an 11-day trial. In a very lengthy and detailed memorandum, it concluded that the price was intrinsically fair to the Tesla shareholders and entered judgment in favor of the defendants. As to the process, the court found that “Elon was undoubtedly involved in the deal process in ways he should not have been, but fortunately, the Tesla Board ensured nevertheless that the process led to a fair price. For example, it said no to the proposed merger twice at the outset. And Elon did not push back against them—there were no threats, fits or fights.  While involved, Elon did not impede the Tesla Board’s pursuit of a fair price.”

As to the price, it found that the price was intrinsically fair. It considered the testimony of various parties and experts and concluded the price was fait to Tesla. It commented also that “approval of a merger by disinterested stockholders is ‘compelling evidence that the price was fair.’  Here, nearly 85% of the votes cast by Tesla stockholders—largely extremely sophisticated institutional investors—were in favor of the Acquisition.”

The court therefore did not rule on the duty of care since there could not be any breach when the process getting to the purchase decision was fair, i.e., what was done was something a reasonably prudent person would have done under similar circumstances. Also again, since the price was fair, there could not be any damages.

Some more thoughts about bar exam question 5

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I thought I would give you a little insight into my thought process in answering question 5. It a good lesson I think in how to answer a law school question and how practicing law really works.

I spent about 40 minutes I think doing the answer I uploaded, maybe a little longer. I changed my mind a bunch of times about the analysis, taking arguments out completely and adding new ones that kept coming to me, going back and forth between the various parts. Even discussing Betty made me think of arguments for or against Arnold so I went back and made changes. I always, always, review. review, review. Refine, refine, over and over.

I uploaded it and went for a walk. During my walk I thought about my answer. It occurred to me that I should have been more clear about the fraud analysis. The false statement was that Arnold told Betty he thought the patent was worth a $100,000. If he really thought that, it’s not a false statement. Plus a belief in something may not even be a statement at all. So the issue really was the failure to disclose the previous attempts to sell the patent. Failure to disclose is not a “false statement” and is fraud only if there is a duty to disclose. Until they were partners I’m not sure there was a duty to disclose. That’s what made me think of Rule 10b5. That has a duty to disclose which I think clearly applies.

The point of this is this is how it works in the lawyer world. You think about something, reach a conclusion, think some more, massage your analysis. There are rarely clear answers to anything. Good lawyers write want they want to tell the judge or the client, then set it aside and look at it again tomorrow. It’s so much more clear the next day.

The second point in this post is when I later reviewed the answer I uploaded I quickly found a typo. I put in the answer that a partnership is when “one or more persons” agree to operate a business. It’s obviously two or more. It’s a stupid mistake and I kick myself. If I had read that in one of your answers, I would have wondered if you knew what the rule was. I likely would have pointed out that it can’t be that one person can be a partnership. Typos happen but it is sooo important they be limited.

The point of my second point is that it is the rare student, from what I can see, that reviews his/her answer at all. That is such a big mistake! What you say in your answer matters. I only know what I am reading. The bar exam reader spends about 3 minutes per exam before giving it a grade. We are trying to figure out how well you know the subject matter by reading your words.

My third point is that when I thought about the answer to part 2 – Betty, I wondered what I would say. The answer is really the same. So I thought about what made the Betty answer different than the Arnold answer which I spent so much time on. Many students these days would have copied and pasted the entire answer re Arnold into the answer re Betty. That is such a bad idea! If Betty were sitting there in your office, you would not just literally repeat what you just told Arnold. You would say, “well Betty, your position is a little different.”

Oh well, the Kings game is about to start. I have to reread this before I upload it. JH

Analysis of California Bar Exam, February 2022

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This question is probably a contract, business associations and torts (fraud) cross-over. Below is the question and my analysis. Note that in a real answer, there would be more space spent stating the relevant rules.

Question 5

Arnold and Betty agreed to launch a business selling a durable paint that Arnold had developed and patented. They agreed to share all profits and to act as equal owners. Betty agreed to contribute $100,000 to the business venture. Arnold agreed to contribute his patent for durable paint. Arnold told Betty that he thought the patent was worth $100,000. He did not tell Betty that he had previously tried to sell the patent to several reputable paint companies but was never offered more than $50,000. Arnold and Betty agreed that Betty would be responsible for market research and marketing and Arnold would be responsible for incorporating the business and taking care of any other steps needed to start the enterprise.

Arnold first located a building within which to operate the business, owned by Landlord Co., and entered into a one-year lease in the name of Durable Paint, Inc.  Subsequently, after Arnold took the necessary steps, Durable Paint, Inc. was incorporated. At the corporation’s first board of directors meeting, Arnold and Betty were named as sole directors and officers. During that meeting, Arnold and Betty voted for the corporation to assume all rights and liabilities for the lease and to accept assignment of Arnold’s patent rights.

Over the next six months, Durable Paint, Inc. faced unforeseen and costly manufacturing and supply problems. At the end of the first six months, the corporation had exhausted all its capital and was two months behind on rent. To make matters worse, a competitor developed a far superior product, making Durable Paint, Inc.’s patent effectively worthless. Durable Paint, Inc. had no other assets.

Landlord Co. sued Arnold and Betty personally for damages for breach of the lease.  Betty sued Arnold.

1. On what theory or theories might Arnold be found personally liable for damages to Landlord Co.? Discuss.
2. On what theory or theories might Betty be found personally liable for damages to Landlord Co.? Discuss.
3. On what theory or theories might Arnold be found personally liable for damages to Betty? Discuss

My Analysis

Part 1:

Arnold and Betty seem to have formed a partnership by agreeing to operate a business selling paint.  They could argue that their agreement at the outset was to form a corporation which would then operate a business.  In other words, they did not intend and did not in fact operate a business until the corporation was formed.  At that point it would own the patent and would have some money and start operating.  But the landlord would argue that the execution of the lease was in furtherance of operating the business so it was “operating.” And courts generally hold that activities by one or more persons before incorporation constitute a partnership. 

There is probably a partnership so they are both personally liable for the debts of the partnership.  Is the lease a “debt of the partnership”?  It was if the partnership was a party to the contract and Arnold had authority to enter into the lease on behalf of the partnership.  The contract indicates that the tenant was a corporation which had not yet been formed.  The corporation cannot be a party to the contract, at least when the contract was entered into.  That leaves it that a contract was entered into by the partnership since it is in furtherance of the partnership business.  Did Arnold have authority to enter into the contract?  There are no facts suggesting he and Betty agreed that he would do that so there is no express authority to enter into the contract.  But they agreed Arnold would be “taking care of any other steps needed to start the enterprise.”  From that Arnold could have reasonably believed he had authority to enter into the lease and thus he had implied authority.  It could also be implied since general partners generally have authority to enter into contracts for the entity.  Thus the partnership is liable and both Arnold and Betty are liable for partnership debts. 

Arnold could also be liable for the debt because he was a promoter of the corporation to be formed.  The general rule is that the promoter is liable for contracts entered into by the promoter on behalf of a corporation to be formed.  Arnold might argue that there was simply no contract because there was no corporation.  He would argue that the parties, i.e., he and the landlord, intended the contract to apply only once the corporation was formed (and not until then).  That would depend on the facts.  He could also argue that the corporation was de facto.  A de facto corporation is one where the parties mistakenly believe a corporation exists.  But here Arnold knew he did not form the corporation.  He could also argue that when the corporation ratified the lease later, that ended his liability for the lease.  But the corporation’s ratification of the lease does not absolve him from the liability unless the landlord agreed to exonerate him.  He might argue that the fact that the landlord intended to enter into the contract with the corporation in the first place, and not with Arnold and/or Betty, and the corporation did in fact assume it, that shows that the parties intended the contract to be enforceable only against the corporation.

If the debt is a corporate debt and not personal to Arnold, the landlord could seek to pierce the corporate veil to make Arnold personally liable for the corporate debt.  But there are no facts that suggest that the corporation and Arnold were alter egos of each other.  There may be an argument that it was undercapitalized since it ran out of money quickly.  But they seemed to have complied with the formalities of operating a corporation, did not form it for any fraudulent purpose and it is not unfair therefore to allow him to be protected by the corporate shield.

Part 2:

The analysis as to Betty is largely the same.  In addition to Arnold’s arguments, she would argue that Arnold had no authority to enter into the lease because the agreement was that they would form a corporation so until then there was either no partnership or there was no authority to enter into a lease.  She would also argue that she was not a “promoter” of the unformed corporation because they agreed Arnold would take care of that part of the business.  Further she did not sign or negotiate the lease.  She is therefore not liable as a promoter.  She would have a little better chance at the de facto argument as she probably believed that the corporation was formed.  The de facto corporation concept does not work in most states.  But it is an equitable argument and the equities are in Betty’s favor, certainly more than Arnold. 

Part 3:

Arnold has definitely misled Betty as to the value of the patent.  Forgetting what kind of entity this might be, if his statements to her about the value of the patent were false, and he knew they were false and intended to deceive her, he has committed fraud and is liable for her damages.  Once a partnership was formed, Arnold also owed Betty a fiduciary duty of loyalty meaning he had an obligation to disclose everything to her that she might need to know, meaning tell her about his prior efforts to sell the patent.  So he has also violated that duty to her and must pay all damages caused by the violation.  If he made false statements to her as part of setting up the corporation, in other words as part of the process of her receiving stock in the corporation, he has an obligation under Rule 10b5 to disclose anything necessary so that the statements he made about the patent was not misleading.  Arnold might argue that the company failed because a competitor created a better product which is not uncommon.  In other words, his lack of candor and disclosure did not cause the injury.   

Study Group Sessions – Business Assn

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I am going to have a study group class tomorrow at 5:00 p.m. It will go until about 6:15 pm. I will send a Zoom invite to those students who would like to attend. Send me an email if you would like to receive the invite. The purpose of the study session to answer any questions students might have. There will generally no new material discussed. So bring your questions.

I expect to do this once a week for most of the rest of the semester. I will have some sessions on Saturday so that those who cannot attend on Wednesday can attend that session. We can discuss that tomorrow.