Academic journal article Boston University Law Review

Conflicted Mutual Fund Voting in Corporate Law

Academic journal article Boston University Law Review

Conflicted Mutual Fund Voting in Corporate Law

Article excerpt


In October 2016, Elon Musk pitched a $2.6 billion merger with SolarCity to Tesla's shareholders.1 He described rising carbon dioxide levels, global warming, and the inevitable transition to a world fueled only by sustainable energy.2 He argued that together, Tesla and SolarCity would forge an "integrated future" for the planet.3 The crowd cheered. Someone yelled "Save us, Elon!"4

What Musk failed to highlight in his fourteen-minute speech was SolarCity's dismal performance. The company's debt had reached $3.4 billion, sales growth had slowed, and it faced a liquidity crisis.5 Without the merger, the company would have faced bankruptcy.6 Perhaps more importantly, Musk failed to mention the pervasive conflicts of interest, both personal and financial, facing Tesla management. Musk chaired both companies and was SolarCity's largest shareholder.7 Beyond these obvious conflicts, SolarCity was founded by Musk's two cousins, with substantial support and encouragement from Musk.8 Musk had taken out millions of dollars in personal credit lines to buy more shares in the company, and his aerospace company, SpaceX, had purchased $165 million in bonds issued by SolarCity.9 Six of Tesla's seven directors had close ties to SolarCity.10

For all of these reasons, the market panned the merger. When news of Tesla's $2.6 billion offer was disclosed, Tesla's stock dropped 10%.11 Jim Chanos, a hedge fund manager that had shorted Tesla and SolarCity, called the acquisition a "shameful example of corporate governance at its worst" and a "bailout" of SolarCity.12 Auto industry experts said the idea of combining the electric-car manufacturer with a solar energy company made no strategic sense.13 Many highlighted existing problems at Tesla as further cause for concern-Tesla was cash-strapped and struggling to meet production goals for its Model X. As expressed in the Wall Street Journal, "Tesla latching on to SolarCity is the equivalent of a shipwrecked man clinging to a piece of driftwood grabbing on to another man without one."14

Nonetheless, the merger was approved by a wide-margin-excluding the votes of Musk and his affiliates, 85% of the company's shareholders voted in favor of the transaction.15 Accordingly, in litigation challenging the merger as the product of pervasive conflicts of interest, lawyers for Tesla contended that the transaction should receive business judgment protection.16 Tesla relied upon Corwin v. KKR Financial Holdings, LLC,17 which protects merger-andacquisition ("M&A") transactions from judicial scrutiny when ratified by "the fully informed, uncoerced vote of the disinterested stockholders."18 Because Tesla's shareholders had voted in favor of the merger, the defendants argued that the plaintiffs had no recourse.

The plaintiffs mounted a novel argument in response. The purportedly "disinterested" Tesla shareholders included large institutional investors who also owned SolarCity stock. The plaintiffs demonstrated that Tesla's top twentyfive institutional investors-those holding 45.7% of Tesla's stock-were standing on both sides of the transaction.19 The plaintiffs claimed that this rendered the institutional investors "interested" and the deal ineligible for business judgment protection.20 Although the Delaware Court of Chancery never ruled on this claim, instead denying dismissal on other grounds,21 the court venutred a prediction that the argument would one day resurface.22 We agree.

That is because institutional investors, mutual fund sponsors23 in particular, increasingly control the outcome of corporate elections. Mutual funds have been around for at least a century,24 but it was not until 1974 that they began to be a force in governance.25 Having been steadily growing for decades, institutional investors' share of U.S. equity markets now stands at over 80%, with mutual funds holding more than half of that amount.26 In the past decade, investor demand for passively managed mutual funds-index funds and exchange-traded funds ("ETFs")27-has rendered the institutions that favor passive management especially powerful: BlackRock now controls 5% blocks of more than half of U. …

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