Readers know that I have been following the SEC enforcement action and the securities class action litigation arising from Tesla CEO Elon Musk’s infamous “take private” tweets. I recently noted that the court in the securities suit about the tweets ruled that the case can go forward. I am sure I am not the only one who has wondered while thinking about these events what kind of D&O insurance Tesla carries. While the question of what kind and amount of D&O insurance might be applicable to the pending claims is interesting, what may be even more interesting is that, according to a recent SEC filing, Tesla recently decided to forego D&O insurance for the current period based on an undertaking by Musk to provide the company and its board with equivalent “coverage,” as discussed below.


On April 28, 2020, Tesla filed with the SEC an amendment to its annual 10-K filing (here). The amendment addresses a number of corporate governance and executive compensation issues. In a section of the filing with the heading “Director Independence,” the company discloses that:


Tesla determined not to renew its directors and officers liability insurance policy for the 2019-2020 year due to disproportionately high premiums quoted by insurance companies. Instead, Elon Musk agreed with Tesla to personally provide coverage substantially equivalent to such a policy for a one-year period, and the other members of the Board are third-party beneficiaries thereof. The Board concluded that because such arrangement is governed by a binding agreement with Tesla as to which Mr. Musk does not have unilateral discretion to perform, and is intended to replace an ordinary course insurance policy, it would not impair the independent judgment of the other members of the Board.


[Hat tip to the various readers who called this item to my attention].


While this arrangement is unusual, it is not unprecedented in my experience. Years ago, right at the outset of the global financial crisis, I ran across a similar arrangement at a privately held commercial bank. The bank’s founder, Chairman, and largest shareholder had provided personal indemnification undertakings to the members of the bank’s board of directors. The Chairman was one of the wealthiest individuals in the bank’s town and indeed in the bank’s state. The bank did not carry D&O insurance.


At the point where I got involved, the bank was on its last lap around the bowl before going down the drain. The board had belatedly concluded that they needed D&O insurance after all. At that point, as the financial crisis was beginning to unfold, there was no D&O insurance available for the bank at any price. The problem for the directors was that the bank Chairman’s wealth was tied up entirely in his ownership of the bank. When the bank became troubled, the value of his stock – and his personal wealth – plummeted. By the time the bank failed, which it soon did, the directors had no D&O insurance and the Chairman’s personal indemnity was worthless. The directors were forced to face the ensuing FDIC receivership with only their own personal assets for protection.


This prior experience underscores the problem for Tesla and its directors with relying on Musk to provide “substantially equivalent coverage.” His agreement to provide coverage to the directors is dependent on his financial ability to honor his commitment. However, the directors’ need for coverage could arise in a set of circumstances that could itself undermine Musk’s ability to honor his commitment. Of course Musk is famously wealthy (albeit with his wealth tied up in companies, including Tesla, with a truly impressive propensity to lose money). But as the above example shows, things can change – things can change in a hurry.  In that regard, it is important to keep in mind that the most important function of D&O insurance is to protect a company’s directors and officers in times of crisis and catastrophe. It might well be that the directors need Musk’s promised “coverage” at the very moment when both Musk and Tesla have both encountered a dramatic reversal of fortunate – as indeed was the case with the bank I described above.


There is another thing about this arrangement and its dependence on Musk’s wealth. The fact is that this arrangement puts the directors in a position in which they have a direct financial interest in Musk being able to maintain his financial well-being. It is in their interest to ensure that Musk remains financially able to honor his “coverage” undertaking to them, which I think sheds interesting light on the statement in the company’s SEC filing that the arrangement does not impair the board’s independence.


Beyond the board’s interest in having Musk maintain his financial ability to honor his commitment to them, there are larger questions about how this arrangement will affect other aspects of the board’s duties. Let’s consider a hypothetical. Let’s assume that a #MeToo allegation against Musk were to come to light. Let’s assume that the allegations are serious, corroborated, and troubling. Let’s assume that the situation is sufficiently serious that the board feels that it must consider whether or not Musk employment as CEO must be terminated. What impact would it have on the board’s deliberations that the availability of insurance-like protection depends on Musk honoring his “coverage” agreement? Keep in mind that the boards of a number of companies whose executives were the subject of #MeToo reports were the targets of derivative lawsuits or securities class action lawsuits. If the #MeToo reports were to result in these kinds of claims against the board, the board members would have to look to Musk’s “coverage” for their defense – what effect might this fact have on the board’s consideration of the issue of whether Musk’s termination is warranted?


There are a number of other things about this announcement that raise questions.  What exactly does it mean that Musk is providing the board with “substantially equivalent coverage” – for example, does his coverage undertaking include exclusions? What are the provision for circumstances where the board is divided – for example, what happens in the event of a claim if a director insists on their own counsel? What happens if there is a serious claim and the directors want to settle but Musk himself wants to fight the claim all the way through trial (as he did in recent months with respect to the defamation lawsuit against him). The SEC filing says that there is a “binding agreement” between Musk and the company, so perhaps many of these issues and many others are actually addressed in the agreement – if so, that is just one more way that this arrangement is so unusual.


One thing I will say is that it comes as no surprise to me that in connection with its renewal for the 2019-2020 policy year that Tesla found that its insurance costs were high. For starters, during 2019, many policyholders found that the cost to renew their coverage was substantially higher than what they had paid for their expiring policy. But while all companies found that their insurance cost increased in 2019, Tesla’s own circumstances almost certainly exacerbated the situation. In the preceding year, Tesla has gotten hit with an SEC enforcement action and a securities class action based on circumstances that would raise questions for anyone concerned about whether Tesla might encounter other claims in the future. The SEC filing says premiums quoted for Tesla’s insurance renewal were “disproportionately high,” to which I say, disproportionate to what? Disproportionate to other companies, or disproportionate to the unquestionably unusual risk profile that Tesla presents?


All of that said, I do have to acknowledge that Musk’s agreement to provide the equivalent of insurance coverage for the company is an impressive gesture. Many companies faced with spiking insurance costs try to figure out if there is an alternative way they can achieve the same result. Some companies in this position come to the reluctant conclusion that they have to pay the increased cost. Other companies wind up reducing the amount of insurance they buy or even try alternative structures (such as buying Side A insurance only) as a way to try to reduce their costs. Very few companies decide to do without insurance altogether, and among the very few who do decide not to buy insurance, even fewer are able to have an undertaking equivalent to insurance from one of its executives.


It is worth noting that Tesla has long had an aggressive approach to limiting its insurance costs. For example, in Tesla’s 2018 10-K, the company said in its Risk Factors in its most recent filing on Form 10-K (here, see page 28):


Our insurance strategy may not be adequate to protect us from all business risks.

We may be subject, in the ordinary course of business, to losses resulting from products liability, accidents, acts of God and other claims against us, for which we may have no insurance coverage. As a general matter, we do not maintain as much insurance coverage as many other companies do, and in some cases, we do not maintain any at all. Additionally, the policies that we do have may include significant deductibles or self-insured retentions, and we cannot be certain that our insurance coverage will be sufficient to cover all future losses or claims against us. A loss that is uninsured or which exceeds policy limits may require us to pay substantial amounts, which could adversely affect our financial condition and operating results.


This statement says nothing specifically about the company’s purchase of D&O insurance, but we can certainly assume that the company’s overall insurance approach affected its D&O insurance purchase. In a way, the company’s latest insurance arrangement, with Musk himself providing the coverage, just takes this overall approach to its logical extreme.