Elon Musk Vs. OpenAI - The Lawsuit

Elon Musk filed a lawsuit last week against OpenAI and its CEO Sam Altman, alleging the company’s deal with Microsoft compromised the start-up’s original mission.  Musk is seeking disgorgement, additional unspecified damages and specific performance. 

Let’s go through these claims one by one, see what legal experts have been saying about the case. We will also discuss the Open AI memo saying that the claims in this lawsuit suit stem from Elon’s regrets about not being involved with the company today and the emails OpenAI released showing that Musk initially supported the plan to create a for-profit entity and wanted a merger that would make Tesla its "cash cow." 

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Papers Mentioned:
Copy of the Legal Complaint: https://assets.bwbx.io/documents/users/iqjWHBFdfxIU/rYCUmwA4Xxpw/v0
Ann Lipton Blog: https://lawprofessors.typepad.com/business_law/2024/03/spins-roulette-wheel-moelis-and-openai.html
Jeremy Tilman Blog: https://lawprofessors.typepad.com/contractsprof_blog/2024/03/musk-v-altman-the-breach-of-contract-claims.html
Matt Levine Article: https://www.bloomberg.com/opinion/articles/2024-03-01/openai-isn-t-open-enough-for-elon
Nilay Patel Article: https://www.theverge.com/2024/3/1/24087937/elon-musk-suing-openai-nightmare-1l-contracts-exam

Transcript

Elon Musk filed a lawsuit last week against OpenAI and its CEO Sam Altman, alleging the company’s deal with Microsoft compromised the start-up’s original mission.  Musk is seeking disgorgement, additional unspecified damages and specific performance. 

The lawsuit is quite interesting for a number of reasons, most of which relate to the unusual corporate structure of Open AI - which was founded as a tax-exempt non-profit, later establishing a holding company that allowed it to take money from investors in a capped profit subsidiary.

The investors in the capped profit subsidiary are not entitled to board seats as they would be in a normal corporation, and the profits returned to investors are capped at 100 times the amount investors initially put in – which many would view as a decent return on investment - but it is still a capped return…

Investors in the for-profit subsidiary were amusingly warned when investing: “It would be wise to view any investment in OpenAI Global, LLC in the spirit of a donation, with the understanding that it may be difficult to know what role money will play in a post-AGI world.”  This is quite unusual…

In essence, this is a breach of contract lawsuit, but – surprisingly - no actual contract appears to exist – which can make things complicated…

The fact that the lawsuit was filed in California is also surprising as it names eight Delaware registered corporate entities as defendants and so you would expect the suit to be filed in Delaware. The fact that it’s not probably relates to Musk’s anger with the Delaware court system.

Musk’s lawsuit asks the court for a judicial determination that Open AI’s GPT-4 software constitutes Artificial General Intelligence. There is (of course) no legal definition for “Artificial General Intelligence” which might make this difficult. The suit requests trial by jury, which means that a jury would be expected to decide on this topic if it went to trial.

The lawsuit accuses Open AI of breech of fiduciary duty to Musk as a donor, but then in other parts of the lawsuit says that the boards sole fiduciary duty is to “humanity.” I guess in mathematical terms – set A is humanity and set B is Elon Musk – and Set B is a very clear subset of Set A – so maybe they do owe him a fiduciary duty.  I’m happy to send this diagram to Musk’s Lawyers and to appear as an expert witness if needed – for a small fee…

There is a section accusing of Open AI of unfair business practices and unfair competition which doesn’t describe any business practices or competitive behavior, but which concludes that the plaintiff is entitled to restitution and/or disgorgement of any and all monies received by the Defendants while Open AI engaged in such practices.

The lawsuit does, however, make a very interesting point relating to tax policy and corporate structure. It argues that if a company can launch as a non-profit - working for the public benefit - and can collect pre-tax donations, later transferring the IP into a for-profit venture once it has become useful, every startup will do this going forward. The lawsuit points out that for every dollar that an investor “invests” by contributing to a non-profit, that investor gets approximately 50 cents back from the state and federal governments in the form of reduced income taxes, so the net cost to investors of each $1 of investment is only 50 cents. That is an attractive way to invest if it’s allowed.

The complaint argues that if the Court validates OpenAI’s conduct, every startup would follow this playbook, to the detriment of legitimate non-profits, the government’s tax coffers, and ultimately the people of California and beyond. So, humanity, I guess…

So, let’s go through these claims one by one, see what legal experts have been saying about the case. We will also discuss the Open AI memo saying that the claims in this lawsuit suit stem from Elon’s regrets about not being involved with the company today and the emails they released showing that Musk initially supported the plan to create a for-profit entity and wanted a merger that would make Tesla its "cash cow." 

Let’s start with the breech of contract claims. One of the biggest problems with the breach of contract claims in this lawsuit is that no actual contract exists. The lawsuit mentions “The Founding Agreement” thirty-two times, but no “founding agreement” actually exists.  Instead, the lawsuit tells us that the founding agreement must be inferred from various emails and conversations between the founders, text from the website of Open AI and the Delaware certificate of incorporation.

The Delaware certificate of incorporation is included as exhibit one and is referenced in the lawsuit as being part of the “Founding Agreement.” A certificate of incorporation is unfortunately not a contract, it is a document you file with a state in order to incorporate a corporation. Musk didn’t sign this certificate, and it gave him no rights as a shareholder, because there are no shareholders in a nonprofit organization – it actually states that on the certificate.

Exhibit 2 of the lawsuit is an email exchange between Altman and Musk, with five bullet points which include questions like “will you be involved somehow in addition to just governance” and “ideally you’d come by and talk to them about progress once a month or whatever”. There is no mention of money anywhere in this exchange. Musk replied to Altman’s email with “Agree on all.”  It is unlikely that a court would see this as being a contract, and even if they did it is not obvious how it supports Musk’s claims.

I should add in – for the sake of completeness – that on page 7 of the complaint it says that in 2023, the defendants set the Founding Agreement aflame. Which is most likely a metaphor – but who knows maybe the reason Musk has not presented anything that looks like a contract is that it was set aflame last year. I feel the lawyers should aim to write with greater clarity.

With regard to the lawsult being filed in California rather than Delaware, Ann Lipton – of Tulane University writes in her business law blog that “Musk claims that he has a contract, formed under California law, that allows him to dictate the governance choices of a Delaware organized (nonstock) corporation, and further, that a California court should order that this Delaware corporation conduct itself in accordance with his contract.”

She goes on to explain that OpenAI as a nonprofit is subject to jurisdiction not only of the Attorney General of its state of organization, but also the Attorneys General of the states where it operates.  

Musk is not an Attorney General and thus can’t bring charges that a nonprofit violated the legal rules governing nonprofits in California; possibly for this reason he is instead claiming a contractual right to dictate the governance of a Delaware-organized (nonstock) corporation.

Lipton argues that if OpenAI wanted to take this as a serious threat, it could file a declaratory judgment action in Delaware to the effect that these “contracts” – if they even exist – are in fact contracts concerning internal affairs - matters governed by Delaware law.  And, under Delaware law, at least at the corporate level, they are illegal intrusions into the board’s authority.

Jeremy Tellman from Oklahoma City University School of law highlights on his blog that with respect to these claims, Mr. Musk seeks unspecified damages but also specific performance of the alleged contractual or non-contractual promises.  

While OpenAI and Microsoft could refund Musk’s investment, and pay any damages claimed, specific performance, is a big ask according to Tellman.  Specific performance means the court requiring open AI to fulfill their contractual obligations. Telman writes “I don't see a court ordering a company to work for the betterment of humankind.”  

To quote the lawsuit, “in addition to disgorgement and damages, Musk seeks specific performance in the form of:

1.           An order requiring that Defendants continue to follow OpenAI’s longstanding practice of making AI research and technology developed at OpenAI available to the public, and

2.           An order prohibiting Defendants from utilizing OpenAI, Inc. or its assets for the financial benefit of the individual Defendants, Microsoft, or any other particular person or entity.

So, if this was granted, Open AI would be required to release all of their work to the public and continue working without any financial benefit. 

In a rather funny article on “The Verge” Nilay Patel dismisses the entire complaint as a nuisance lawsuit that is likely to be dismissed by the court. He writes that Musk’s lawyers have figured out that letting the world’s richest man rack up billable hours filing nonsensical lawsuits is more lucrative than fitting the “facts” to the “law,” or whatever it is regular lawyers do.

He writes that the breach of contract claim admits that the “Founding Agreement” is basically a vibe everyone caught in some emails.

Moving on from the breach of contract claims, the breach of fiduciary duty claim does not hold much water either.  

The Supreme Court clarified in Atherton Vs FDIC that under the “internal affairs doctrine” the law of the state of incorporation of the organization is the applicable law regarding the fiduciary duties of corporate directors and officers. So, this part of the case would need to be litigated in Delaware, not in California.  

Under Delaware case law, directors are charged with an unyielding fiduciary duty to protect the interests of the corporation and to act in the best interests of its members.  As I mentioned earlier are no members or shareholders in a Delaware nonprofit corporation and the board thus has no fiduciary duty to Musk.

The Financial Times wrote in an article on Thursday that the lawsuit reads like a mash-up between a science fiction film script and a letter from a jilted lover.

The section on unfair business practices is confusing.  It doesn’t describe any business practices or competitive behaviors, but it does say that the practices deceived Musk and are likely to deceive other members of the public.

The most interesting part of the lawsuit, as I mentioned earlier is the section on how availing of tax breaks by launching as a nonprofit before transferring the IP into a for-profit venture once the technology has been proved, if allowed would mean that all startups would follow this path.  I don’t know if a California court can judge on this, but it does appear to be quite a tax loophole that other startups could possibly exploit.

Sometimes companies find and exploit tax loopholes and if a government decides not to close them up they go on to become the way things are done going forward.  The US government might decide that they are happy to allow this loophole in order to incentivize investment in startups.  The 401K retirement plan came about when Hughes Aircraft Company used a loophole in the IRS revenue code to convert its after tax savings plan into what we now call a 401(k) plan.

While Musk has highlighted this issue in his lawsuit, I don’t believe the California court will decide on an issue like this, but the press around this lawsuit may draw the attention of the Office of Tax policy.

In the wake of the lawsuit, OpenAI Chief Strategy Officer Jason Kwon wrote an internal memo which was seen by numerous press organizations which said “We believe the claims in this suit may stem from Elon’s regrets about not being involved with the company today.”

OpenAI disputes Musk’s version of events and has moved to dismiss his legal claims. In a blog post this Tuesday, Open AI’s co-founders released a number of emails sent by Elon Musk which show that Musk had supported OpenAI’s move to create a for-profit business entity and had even wanted to fold the company into Tesla.

The blog post says “In late 2017, we and Elon decided the next step for the mission was to create a for-profit entity. Elon wanted majority equity, initial board control, and to be CEO. In the middle of these discussions, he withheld funding. Reid Hoffman bridged the gap to cover salaries and operations”.

In one of the released emails Musk discouraged making the research freely available saying “If you can't seriously compete - but continue to do research in the open, you might in fact be making things worse and helping them (meaning Google) out “for free”, because any advances are fairly easy for them to copy and immediately incorporate, at scale.

In the same 2018 email he writes “A for-profit pivot might create a more sustainable revenue stream over time and would, with the current team, likely bring in a lot of investment.”

He goes on to say “The most promising option I can think of, as I mentioned earlier, would be for OpenAI to attach to Tesla as its cash cow”.

The Open AI founders claim that Elon soon chose to leave OpenAI, saying that our probability of success was zero, and that he planned to build an AGI competitor within Tesla. When he left in late February 2018, he told our team he was supportive of us finding our own path to raising billions of dollars.

Musk’s lawsuit is asking the court to return his donations, pay him damages and for an order forcing Open AI to release all of their source code into the public domain and end Microsoft’s exclusive license agreement.

The court will be aware that Musk runs a competing for-profit artificial intelligence company called xAI along with other companies that claim to use Artificial Intelligence like Tesla and Twitter. Matt Levine at Bloomberg points out that Musk’s protests about OpenAI’s unseemly pursuit of AI profit for investors looks a little insincere, since he is doing the exact same thing at his other firms.  The Center for AI Policy wrote in an open letter on their website that “It’s possible that Musk is simply techwashing and creating chaos in the marketplace,”

The unusual corporate structure of Open AI has allowed Microsoft to put billions of dollars into the company over the last several years. OpenAI is using Microsoft’s computing resources to develop its technology, and Microsoft is integrating OpenAI’s services into its core products.

Microsoft has been able to do this without attracting antitrust scrutiny as they claim to not exercise any control over the limited for-profit company controlled by a nonprofit organization. That lack of control has since been called into question after Microsoft stepped in when Sam Altman was fired late last year.

The Justice Department and the Federal Trade Commission are now reported to be deep in discussions over which agency can probe Microsoft’s involvement with Open AI on antitrust grounds.

The relationship between the two firms has additionally drawn scrutiny from the UK’s Competition and Markets Authority and The European Commission.

I’m not sure that Musk’s lawsuit will lead to much.  Noah Feldman, a professor at Harvard Law School told the New York Times that the contract Musk claims OpenAI and Altman breached contains “a hole you can drive a truck through.” OpenAI’s certificate of incorporation, which Musk’s lawyers claim is part of the “Founding Agreement”, says the A.I. maker will seek to open its work to the public for its benefit “when applicable” — and OpenAI can easily argue that it is adhering to this term, which is vague.

While the lawsuit itself may not be awfully interesting, it does highlight the unusual structure of Open AI which has all sorts of tax and anti-trust implications which are of great interest in Corporate Finance. 

Thanks for tuning in to this week’s podcast, with a special thanks to our supporters on Patreon who make this podcast possible.  Have a great week and talk to you again soon, bye.