Tesla is testing whether stockholders have the power to overrule a judge

Tesla’s ( TSLA ) court fight to restore Elon Musk’s pay poses an undecided question that could remake the rules of corporate law: Can stockholders ever overrule a judge?

The electric vehicle maker says the answer is yes.

The company is asking the same Delaware business court judge who voided Musk’s $56 billion CEO compensation pact in January to toss out her decision and replace it with the will of the company’s stockholders, who approved the pay a second time in June.

"This has never been done before," the judge, Chancellor Kathaleen McCormick of the Delaware Court of Chancery, said at a hearing earlier this month.

Tesla’s lawyer agreed, but argued the new shareholder decision should hold final sway.

"This was stockholder democracy working," he said.

Corporate law attorneys predict that pitch won’t be enough to change Chancellor McCormick’s decision.

They say the question at the heart of the case could move ahead on appeal as far as the US Supreme Court.

A 'cleansing'

Tesla's argument is that shareholders, not judges, should decide corporate transactions. Otherwise, the wider business world will lose faith that they can rely on the agreements they reach with their stockholders.

And as a general rule, Delaware courts take shareholder votes extremely seriously, making them inclined to defer to the outcome of those tallies.

"I don’t see how Delaware law can tell owners of a company that they can’t" set CEO pay, Rudolf Koch, a lawyer for Tesla’s board, said during the August hearing before Chancellor McCormick.

But what could trip up Tesla is that it may have missed some steps that could have rendered the shareholders' lawsuit moot.

Legal experts point to a series of cases in the state’s business court known as the M&FW line of cases that showcase the path Tesla could have taken — but didn’t.

The decisions in those cases held that even when a corporate transaction involved a conflicted controlling shareholder — as a judge ruled was the case with Musk and Tesla — it was possible for a company to "cleanse" the transaction with the right kind of shareholder vote.

But here’s the potential problem: Case law instructs that Musk must have met the cleansing conditions before he engaged in substantive negotiations with Tesla over his pay deal and conditioned the deal on shareholder approval, according to New York University law school professor Marcel Kahan.

That will be difficult for Musk to prove. No new negotiations appear to have taken place before Tesla re-submitted Musk’s pay deal to stockholders in June.

And still there’s another problem: Even if Judge McCormick finds Tesla’s second vote "cleansed" Musk’s pay deal, she may find Tesla simply waited too long before holding its redo vote.

Delaware’s Chancery Court takes timeliness and reasonableness of corporate actions into account, corporate law attorneys said, and may not tolerate that Tesla waited until after the judge had ruled against it to seek new shareholder approval.

No matter the outcome, Tesla could appeal a defeat to Delaware’s Supreme Court. Those judges, according to Kahan, could rule that Musk was not a controlling shareholder and the requirement to condition the pay deal on shareholder approval does not apply.

Many companies, he added, don’t have to worry about how this case turns out because most adhere to good governance policies that protect them from a judge undoing their transactions.

"So if I'm [JPMorgan CEO] Jamie Dimon, and I read [McCormick’s] opinion, I am not at all worried that my compensation package is going to be at risk."

Alexis Keenan is a legal reporter for Yahoo Finance. Follow Alexis on X @alexiskweed .