Would Your Stockholder Agreement Hold Up in Court?

In a rebuke to common practice, the Delaware Court of Chancery recently struck down most of the governance provisions in a corporate stockholder agreement, dealing a blow to the validity of terms that are in widespread use as bargained-for corporate control mechanisms. Vice Chancellor Travis J. Laster was well aware that his decision was at odds with conventional practice, opening his decision with the rhetorical question, “What happens when the seemingly irresistible force of market practice meets the traditionally immovable object of statutory law?,” to tee up the predictable answer, “the statute prevails.”

The decision in West Palm Beach Firefighters’ Pension Fund v. Moelis & Co., 311 A.3d 809 (Del. Ch. Feb. 23, 2024) threw out a laundry list of stockholder veto rights along with a series of individual provisions that were intended to govern the composition of the board and board committees and the nomination and election of directors. The Court noted that many of these provisions would have been valid if included in the corporation’s certificate of incorporation instead of in the stockholder agreement.

Who is Affected?

The decision affects stockholder agreements for corporations. It does not speak to documentation practices in limited liability companies and partnerships. While its holding is limited to Delaware corporations, the language and purposes of comparable parts of New York’s Business Corporation Law suggest that it might find a receptive audience in the New York courts as well.

Why it Matters.

Stockholder agreements are an important part of the landscape for public and private corporations large and small. Lawyers routinely recommend and draft them to fill in the gaps in corporate statutory and case law in ways that fulfill the expectations of minority and majority shareholder groups alike.

Some of their content seeks to restrict transfers of shares to unwanted third parties or to create liquidity for shareholders upon events like death or separation from the business. These contract terms are unaffected by the decision. However, many others are intended as controls on the management and business of corporations. These include procedures around the composition and election of the board and so-called protective provisions and covenants that purport to give certain shareholders or groups of shareholders a say in the conduct of the corporation’s business. For instance, some provisions require their consent before the corporation can enter into contracts or business arrangements of specified types. These were the grist for Chancellor Laster’s mill in Moelis.

The Moelis rationale reaches governance provisions in stockholder agreements found in private equity, venture capital, closely held businesses of all kinds and—as in Moelis—the public company arena. Notably, just weeks after Moelis was decided, the National Venture Capital Association revised its industry-standard Model Investors’ Rights Agreement to align with the Moelis holding.

What Happened in Moelis.

Moelis & Company (the “Company”) is a boutique global investment bank. Ken Moelis was its eponymous founder, CEO, and Chairman of the Board. After years of success operating the investment bank as a private entity, he decided in 2014 to raise capital from the public markets. One day before the Company’s shares began trading publicly, Moelis, three of his affiliates, and the Company entered into the stockholder agreement that was at issue in the case with the goal of securing Mr. Moelis’ control of the Company for the indefinite future. To this end, it compelled the Company’s board to:

  • obtain Mr. Moelis’ prior written consent before taking any of eighteen different categories of action (the “Pre-Approval Requirements”)[1]—which ominously for their validity, the Court found to encompass virtually everything the board could conceivably do, observing that as a result of them, the board could only act if Mr. Moelis signed off in advance;
  • ensure that Mr. Moelis could select a majority of its members (collectively, the “Board Composition Provisions”);
  • maintain its size at not more than eleven seats (the “Size Requirement”);
  • permit Mr. Moelis to name the number of designees equal to a majority of those seats (the “Designation Right”);
  • nominate Mr. Moelis’ designees as candidates for election (the “Nomination Requirement”);
  • recommend that stockholders vote in favor of Mr. Moelis’ designees (the “Recommendation Requirement”);
  • use reasonable efforts to enable Mr. Moelis’ designees to be elected and continue to serve (the “Efforts Requirement”);
  • fill any vacancy in a seat occupied by a Moelis designee with a new Moelis designee (the “Vacancy Requirement”), with the effect that even if Mr. Moelis held less than a majority of the Company’s outstanding voting power (as was true at the time of the decision), his designees would control the board; and
  • populate any board committee with a number of Mr. Moelis’ designees proportionate to the number of designees on the full board (the “Committee Composition Provision”).

Nothing happened for almost a decade—until a disgruntled investor challenged the agreement in court.

The Moelis Decision.

Unmoved by the longevity of the arrangement or the fact that it had been fully disclosed to stockholders from the time of the IPO to the present, the Court held it up against the seminal teaching of the Delaware General Corporation Law (“DGCL”) that “the business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation” (DGCL Section 141(a)).

And found it wanting. Applying a two-step approach, the Court asked:

  1. does the provision at issue constitute part of the corporation’s internal governance arrangement; and
  2. does it have the effect of removing from the directors in a very substantial way, their duty to use their own best judgment on management matters?

Under this rubric, the challenged provisions were found to be prototypical governance provisions in a prototypical governance agreement. This was true because (i) many of the challenged provisions were ones that touched on governance arrangements that were specifically regulated by the DGCL, (ii) the stockholder agreement was made by “intra-corporate actors” rather than with outside commercial business counterparties, (iii) the challenged provisions sought to set the terms on which these intra-corporate actors could authorize the exercise of corporate powers, (iv) unlike contracts with lenders or commercial counterparties, the agreement was not set in a context of underlying commercial exchange, (v) unlike governance provisions in, say, a loan agreement, these governance provisions could not be justified as protections for a commercial transaction with an outside commercial party, and (vi) unlike most commercial contracts and like governance agreements generally, this agreement was of “enduring, even indefinite” duration, not easily terminable by the Company.

This was not a promising start for Mr. Moelis, and the Court’s excursus into the considerations for the second factor did not go much better for him.

Looking at the Pre-Approval Rights through the lens of the second, “board’s best judgment” prong, the Court found them invalid on their face when taken together because, as noted above, they encompassed “virtually everything the Board can do.” In this batch process analysis, the Court left open whether one or more of them would have survived scrutiny on their own.

The Court also found that the Size Requirement, the Recommendation Requirement, the Vacancy Requirement and the Committee Composition Requirement were invalid on their face because they stripped the board of its ability to use its best judgment in deciding whether to recommend a board candidate to the stockholders and determine, when permitted by the DGCL and the Company’s charter, the composition of the board and its committees.

The Court did give a pass to the Designation Right, the Nomination Requirement and the Efforts Requirement, finding them to be rights that are within the purview of shareholders as such and that the add-on contractual requirement that the Company support the exercise of these rights was not facially invalid—while noting that even these provisions could be subject to challenge in another setting, according to the facts.

The Court pointed out that many of the stricken provisions would have survived challenge had they been included in the Company’s charter (or in a certificate of designation for preferred stock, which is the equivalent). But probably not all of them would have gotten over the Moelis hurdle even by this means. For instance, agreements (so-called direct, board-level restrictions) that purport to bind the board or its members individually to a course of action or forbearance will almost always fail as prohibited internal governance arrangements.

Is There a Fix?

Maybe and kind of. In response to Moelis, the Council of the Corporation Law Section of the Delaware State Bar Association proposed amendments to the DGCL that would legislatively overturn parts of the decision. These have been advanced to the Delaware General Assembly in the form of Senate Bill 313.

The thrust of the proposed amendments would bless provisions in contracts with corporations that would be seen as invading the decisional space of boards under existing law.  These provisions could even mandate that boards or individual directors take or refrain from taking future actions specified in the contract. Importantly, though, the proposed amendments would not relieve any directors, officers or stockholders of any fiduciary duties they owe to the corporation or its stockholders, including with respect to deciding to cause the corporation to enter into the contract in the first place or to cause the corporation to perform, or to breach, the contract. The proposed amendments have sparked pushback from commentators who think they go too far in turning over board powers to influential stockholders.

Even if the proposed amendments are adopted, it might still be better to put the provisions into the certificate of incorporation. This is because the corporation’s breach of a stockholder agreement provision under the proposed amendments might still allow only for breach of contract claim remedies as distinguished from the more powerful equitable remedies, including potentially blocking the breach, that might be available under a certificate provision.

If adopted, the amendments could become effective as early as August of this year and would apply both prospectively and to existing agreements.

The Delaware Supreme Court will also have the opportunity to weigh in on an appeal of the decision.

Lessons From Moelis:

  • The case applies only to corporations and does not extend to partnerships or limited liability companies organized under Delaware law or any other law.
  • Although the case was decided under Delaware corporate law, it is possible that a court looking at New York’s corporate law would reach similar conclusions.
  • The case may change how governance rights are addressed in corporate control documentation, with typical veto rights and rights to board seats being included in the certificate of incorporation or a certificate of designation for preferred stock. 
  • Parties to stockholder agreements should consider whether there is any action they should take in response to this decision. 
  • The decision may still be modified or overturned by the Delaware Supreme Court, or its holding may be overruled, at least in Delaware, by statute. 

If you have any questions about the final rules, please contact a member of Harter Secrest & Emery’s Corporate group.

[1] A list that included incurrence of indebtedness above a specified amount, issuances of equity in excess of certain thresholds, issuance of any preferred stock, investments, mergers, removal or appointment of any specified officers, charter amendments, declaration or payment of dividends, liquidation, amendments to material contracts; initiation or settling material litigation and commencing any voluntary liquidation.

Attorney Advertising. Prior results do not guarantee a similar outcome. This publication is provided as a service to clients and friends of Harter Secrest & Emery LLP. It is intended for general information purposes only and should not be considered as legal advice. The contents are neither an exhaustive discussion nor do they purport to cover all developments in the area. The reader should consult with legal counsel to determine how applicable laws relate to specific situations. ©2024 Harter Secrest & Emery LLP