United States: Delaware Court Of Chancery Invalidates Certain Rights In Stockholder Agreement Sidelining Board Of Directors

Key Takeaways:

• The Delaware Court of Chancery (the "Court"), through its decision in Moelis¹, has invalidated certain stockholder agreement provisions that circumvent the role of the board of directors (the "Board") and its ability to exercise control pursuant to Section 141(a)² of the Delaware General Corporation Law (the "DGCL").
• Existing stockholder agreements limiting the powers of the board could be held invalid pursuant to Section 141(a) of the DGCL to the extent that such agreements limit the control and powers of the board.
• The ruling in Moelis implies that certain negative covenants related to boards of directors should appear in the company's certificate of incorporation instead of in stockholder agreements to be enforceable.
• The Court's decision only applies to corporations and does not extend to limited liability companies and limited partnerships.

On February 23, 2024, the Court issued an opinion³ invalidating certain provisions of a stockholder agreement, which, in part, contractually constrain the Board's discretion to exercise control over the business and affairs of the company. In its analysis, the Court used a test formulated in Abercrombie⁴ to determine the legality of a stockholder agreement's provision. Accordingly, to determine the validity of a provision, one must first evaluate whether a subject provision falls into the realm of an internal governance arrangement as contemplated in Section 141(a) of the DGCL. Second, if the provision is part of an internal governance arrangement, the Court must determine whether the challenged provision effectively removes the board in a "very substantial way from their duties to use their best judgement on corporate matters."⁵

Drawing off the facts of the case, the Court specifically stated that certain provisions of a stockholder agreement were facially invalid. Such provisions relate to "Pre-Approval Requirements," "Board Composition Provisions," and "Committee Representation Provisions," which are described in more detail below. In Moelis, the Court reasoned as follows:

• "Pre-Approval Requirements" – Under the terms of the company's stockholder agreement, the Board required prior written consent from the stockholder before taking certain actions, which among other matters, included the issuance of equity, removal and appointment of officers, and incurrence of debt. The Court did not consider "whether some lesser combination of rights might pass muster" because these stockholder pre-approval requirements "encompass virtually everything the Board can do,"⁶ and effectively removed the power of a company's Board.
• "Board Composition Provisions" – The Court additionally held that certain Board composition provisions were facially invalid. First, the Court invalidated a provision that required the Board to fill a vacancy created by a departing stockholder-designated Board member to be filled with another stockholder designee. The second provision improperly compelled the Board to recommend a stockholder's designee for Board election. Third, the Court invalidated a provision preventing the Board from increasing the number of board seats beyond a certain amount unless the stockholder provides prior consent, which was counter to the company's certificate of incorporation and bylaws. Notably, the Court stated that (i) a stockholder can (x) "identify a number of candidates for director equal to a majority of the Board"⁷ and "identify a number of [Board] candidates"⁸, and (y) require the Board to nominate a stockholder's designee⁹, and (ii) a company can agree to "facilitate the election and continued service of [stockholder's] designees" as such efforts could be ministerial in nature.¹⁰
• "Committee Representation Provisions" – Lastly, the Court considered a right that forced the Board to "populate any committee with a number of Moelis' designees proportionate to the number of designees on the full Board."¹¹ The determination of a committee's composition is within the Board's authority. Removing that authority is in direct violation of Sections 141(a) and 141(c) of the DGCL.

In delivering its opinion, the Court discussed the methods a company could use to implement facially invalidated provisions. The Court stated that a such company could accomplish the same ends by including language within its certificate of incorporation. Additionally, a corporation could issue a new series of preferred stock carrying a set of voting and appointment rights similar to those refuted by the Court; "it could consist of a single golden share."¹²

It remains to be seen if the Moelis decision will be appealed in the future or how the court will view stockholder agreements and their provisions going forward. However, a company should carefully consider the arrangements related to the decision making of its board of directors as this decision opens the door to legal challenges. At its core, the Moelis decision is a reminder that the powers of the board of directors as to the governance of the company are set forth in the DGCL. This ruling emphasizes the importance of Section 141(a) of the DGCL and, in its wake, Delaware corporations should be careful to not run afoul of its core principle that a corporation "shall be managed by or under the direction of a board of directors, except as [] provided [ ] in its certificate of incorporation." As a practice point, the powers of the board of directors cannot be restricted other than through the provisions in the certificate of incorporation, which may provide exceptions to the board's management authority. Thus, companies should consider incorporating relevant provisions from their stockholder agreements into their certificate of incorporation where applicable. However, companies should not expect that all provisions lifted from stockholder agreements and placed in the certificate of incorporation would automatically become enforceable (for example to the extent such provision would be in violation of the DGCL). It further remains to be seen how subsequent case law, legal commentary and actions by the Delaware courts to amend the DGCL (if any) will clarify this situation at hand.

Footnotes

1. West Palm Beach Firefighters' Pension Fund v. Moelis & Company, C.A. No. 2021-0309-JTL (Del. Ch. Feb. 23, 2024).

2. DGCL Section 141(a) provides 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."

3. West Palm Beach Firefighters' Pension Fund, C.A. No. 2021-0309-JTL.

4. Abercrombie, et al. v. Davies et al., 35 Del. Ch. 599, 611, 123 A.2d 893, 899 (Del. Ch. 1956).

5. Id. at 611.

6. Id. at 4.

7. Id. at 11.

8. Id. at 11. The Court states that "What the Board or the Company does with those candidates is what matters."

9. Id. at 11. This is distinguished from a requirement causing the Board to support a nominated candidate.

10. Id. at 121.

11. Id. at 5.

12. Id. at 13.

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