“Market Practice is Not Law”: Delaware Court of Chancery Invalidates “New Wave” Stockholder Agreement Constraining Board Authority

This enduring cornerstone of Delaware corporate law is rooted in Section 141(a) of the Delaware General Corporate Law (“DGCL”):

“The business and affairs of every corporation […] 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.” ¹

In a recent opinion, ² Vice Chancellor Laster of the Delaware Court of Chancery addressed the conflict between this fundamental statutory board authority and common market practice for agreements that provide stockholders with consent/veto rights over specified corporate actions and other rights as to board and committee representation, concluding that the statute prevailed when the agreement imposed significant governance constraints on the board’s ability to exercise that authority. 

The Court’s ruling offers important considerations for both public corporations negotiating agreements that provide governance rights to stockholders and for private corporations, including those considering an initial public offering. In either case, corporate planners will need to be mindful of the decision’s implications when crafting contractual provisions granting powers to stockholders that have the potential to usurp the board’s authority.

Importantly, the opinion offers a potentially straightforward roadmap for corporations seeking to properly implement the same types of stockholder rights provisions that were invalidated here, but the consequences of this case may pose challenges to public and private corporations that have such agreements in place today.

Key Takeaways

• Internal governance arrangements for stockholders belong in a corporation’s charter
• Review of existing stockholder agreements may be warranted
• Care should be taken in negotiating other types of agreements with stockholders (e.g., activist settlement agreements)
• This ruling does not extend to analogous governance provisions applicable to limited liability companies and limited partnerships, though entities considering a pre-IPO conversion should take note
• Certain provisions in merger and other corporate transaction agreements remain in the gray area between internal governance arrangements and commercial provisions

Factual Background

In connection with the IPO of an investment bank (the “Company”), its founder, Chairman and CEO (the “Founder”) and three companies controlled by him entered into a stockholder agreement with the Company (the “Stockholder Agreement”), which granted him expansive rights and control over the Company’s board of directors (the “Board”).

These rights were extensive, including 18 categories of pre-approval requirements (the “Pre-Approval Requirements”), board composition provisions (the “Board Composition Provisions”), and a committee composition provision (the “Committee Composition Provision”). The Board Composition Provisions required that the Company maintain a Board of not more than 11 directors (the “Size Requirement”), allowed the Founder to designate a number of director candidates equal to a majority of the Board (the “Director Designation Requirement”), required that the Company nominate the Founder’s designees for election as directors (the “Nomination Requirement”), required that the Board recommend in favor of the Founder’s designees (the “Recommendation Requirement”), required that the Company take all reasonable actions within its control to cause the Founder designees to be elected and remain in office (the “Efforts Requirement”), and finally, allowed the Founder to require the Company to replace any of his designees who leave the Board with a new designee (the “Vacancy Requirement”).

The plaintiff – a public stockholder in the Company – filed a claim alleging that the Pre-Approval Requirements, Board Composition Provisions and Committee Composition Provision in the Stockholder Agreement (together, the “Challenged Provisions”) violated Section 141(a).

Legal Analysis

The Court established that a two-step inquiry applied to Section 141(a) claims:  First, is the challenged provision part of an internal governance arrangement? If yes, ³ then the arrangement is subject to Section 141(a) and the analysis proceeds to the second step. Second, does the challenged provision improperly restrict the Board? This prong, a.k.a. the “Abercrombie test,” arose from the Delaware Court’s seminal decision in Abercrombie v. Davies, establishing that “governance restrictions violate Section 141(a) when they have the effect of removing from directors in a very substantial way their duty to use their own best judgement on management matters.”⁴

Step One: Are Challenged Provisions part of a “Governance Arrangement”?

The Court found that the Challenged Provisions were “prototypical governance provisions in a prototypical governance agreement.”⁵ As such, the Stockholder Agreement was subject to Section 141(a). The Court noted that the Stockholder Agreement self-evidently regulated the Company’s internal affairs and in substance was a bilateral agreement between the Company and the Founder with no underlying bargain. The Challenged Provisions bound the Board (and not the Company) for an indefinite period and could not be terminated at the option of the Board.

In reaching this conclusion, the Court rejected the Company’s argument that all “contracts necessarily constrain a board’s freedom of action” and differentiated between an internal governance arrangement and an external commercial contract. Analogizing the Company’s argument to a sorites paradox, the Court remarked that “no one would mistake the Stockholder Agreement for a supply arrangement, credit agreement or some other external commercial contract.”

Step Two: Do the Challenged Provisions Pass the Abercrombie Test?

The Court ruled that most of the Challenged Provisions failed the Abercrombie test. The Pre-Approval Requirements were found to be “direct, board-level restraints”⁶ and when taken together, improperly forced the Board “to obtain [the Founder’s] prior written consent before taking virtually any meaningful action.” ⁷  Noteworthy in this context was the Court’s consideration of the Pre-Approval Requirements collectively rather than individually. As such, the Court did not consider whether a lesser combination of approval rights could pass muster. Significantly, the Court observed that redrafting the “Pre-Approval Requirements” as veto rights would not change the analysis. “If framed as eighteen vetoes, the provisions still would give [the Founder] the ability to block virtually anything the Board might do.” ⁸

Similarly, the Recommendation and Vacancy Requirements were found to improperly compel the Board to recommend voting in favor of the Founder’s Board designees and to fill vacancies created by departing Founder designees with the Founder’s hand-picked replacements. The Size Requirement improperly enabled the Founder to prevent the Board from increasing the number of Board seats beyond the set limit of 11. Finally, the Committee Composition Provision impermissibly shifted the power of committee composition from the Board into the hands of the Founder. In each of these cases, the Court found that the applicable provision had the effect of prohibiting the Board from effectively exercising its judgment and authority as to a matter that fell squarely within its sphere of duties and responsibilities under Section 141(a).

The Court, however, observed that each of the Director Designation Requirement, the Efforts Requirement and the Nomination Requirement in itself did not violate Section 141(a) as the Founder could identify its designees to the Board and the Board could nominate them for election to the Board and comply with the Efforts Requirement with respect thereto, in each case without de facto improperly limiting the Board’s authority. ⁹

Dicta on Framing Internal Governance Arrangements in Compliance with Section 141(a)

The Court suggested a few alternatives to accomplish Section 141(a)- compliant governance arrangements of the type invalidated in the case. Specifically, the Board could still implement the vast majority of Challenged Provisions by invoking its blank check authority, issuing a “golden share” of preferred stock carrying voting and designation rights in favor of a shareholder and including the arrangement in the certificate of designation for the new stock. Since the certificate of designation is a part of the charter, the charter provisions (to the extent they do not override any mandatory feature of the DGCL) would comply with Section 141(a). Alternatively, the provisions could be validly implemented by including them in a company’s certificate of incorporation itself.

Key Takeaways for Corporate Governance and Implications for Current and Future Agreements with Stockholders

While it remains to be seen whether an appeal will be successfully pursued, the case offers keen insights into contractual provisions that encroach on board authority. 

1. Course correction of “new wave” stockholder agreements – internal governance arrangements for stockholders belong in a corporation’s charter

The decision intends to course-correct the market practice of stockholder agreements that impose constraints on the board instead of focusing solely on stockholder-level rights. Board-level governance constraints should appear in the charter, not in stockholder agreements. For instance, certain veto, voting and designation rights can be included in a company’s certificate of incorporation (including at the time of its IPO) or can be tied to preferred stock issued using the blank check authority of a corporation and reflected in the certificate of designation, which forms part of the corporation’s charter. Notably, investors negotiating a PIPE transaction may favor a preferred stock structure and include board representation and other minority governance rights in the certificate of designation to minimize the risks of challenges. Alternatively, provisions found in stockholder agreements could be incorporated by reference into the charter, which could simplify the amendment process but would still require a stockholder vote in situations where the agreement exists but is not already so incorporated. 

2. This ruling does not extend to analogous governance provisions applicable to limited liability companies and limited partnerships, though entities considering a pre-IPO conversion should take note 

This ruling does not extend to analogous governance provisions in limited liability company (“LLC”) or limited partnership (“LP”) agreements. A substantial number of privately-held business enterprises are organized as LLCs or LPs, and while these contractual governance arrangements are not implicated by the decision, LLCs and LPs will need to consider the issues it raises at such time as they begin any plan to go public as the IPO typically will be preceded by conversion from an LLC or LP to a corporation.  

3. Review of existing stockholder agreements may be warranted

As stockholder agreements now will tend to be fertile grounds for Section 141(a) claims, a review of existing stockholder agreements may be necessary where the agreement could improperly give stockholders the power to restrict the board’s judgment, particularly if akin to the rights in the decision, including:

• requiring written stockholder consent before the board can take a range of actions;
• allowing a minority stockholder to have significant impact on board size and composition, through provisions similar to the Size Requirement, Recommendation Requirement or Vacancy Requirement in the decision; and 
• allowing a stockholder to compose board committees.

Companies that have agreements in place today that include provisions of the type invalidated under may conclude that it is advisable to take action to preserve the relevant rights and obligations of the parties through alternative means. Whether and how they will do so will depend to a large extent on the facts and circumstances in each instance and the range of outcomes across these instances will vary widely.

Determinations as to whether to seek to implement an alternative arrangement and the optimal process for doing so will involve a range of factors and considerations, such as the fiduciary duties of the company’s board (including any heightened standard of review that may apply), any conflicts of interest relevant to the process, the number of shareholders party to the existing agreement and the dynamics of the relationship among them and with the company (including their existing board representation), the facts and circumstances at the time the parties entered into the existing agreement, the corporate approvals needed to effect the alternative arrangement (including a potentially costly and highly scrutinized stockholder vote process for listed companies) and other applicable risks and considerations.

4. Care should be taken in negotiating other types of agreements with stockholders 

Boards involved in approving agreements with stockholders in other contexts, such as with activists and minority investors, should be careful to ensure that the directors can effectively carry out their statutory and fiduciary duties without improper limitations under these agreements. The decision reaffirms the board’s authority and director fiduciary duty as fundamental principles of Delaware corporate law that cannot be abrogated through an agreement between stockholders. 

In particular, the decision provides high-level guidance regarding activist settlement agreements, noting that provisions that resemble the Director Designation Requirement, the Nomination Requirement and the Efforts Requirement “would likely pass muster” while provisions that resemble the Recommendation Requirement, the Vacancy Requirement or the Size Requirement “could be problematic, particularly if, as [in the decision], the provisions purported to bind directors irrespective of future events.” ¹⁰

5. Certain provisions in merger and other corporate transaction agreements remain in the gray area between internal governance arrangements and commercial provisions

Vice Chancellor Laster’s opinion included a comprehensive review of precedent Delaware cases under which various contractual or governance agreements and provisions were found to be in conflict with Section 141(a), including the relevant findings in the Ace ¹¹, QVC ¹²  and Omnicare ¹³ decisions, each of which is well-known to M&A practitioners. The decision also provided a review of the distinguishing features of commercial agreements as compared to governance agreements, including a framework centered around the notions of bargain and commercial purpose: while in a commercial agreement, “the bargain is the point and the governance rights protect the bargain,” in a governance arrangement, “the governance rights are the point”.¹⁴  In this context, Vice Chancellor Laster noted that the Ace, QVC and Omnicare decisions were “challenging and remain controversial” because the contractual provisions at issue in each “fell at the intersection of governance and commercial rights.”¹⁵

* * *

This decision left many questions unanswered and we expect further developments in connection with parallel disputes pitting controlling investors against minority stockholders (particularly in private equity backed companies where similar governance arrangements are customary) as well as a possible appeal in this case. Companies are advised to consider the issues raised by the case while awaiting further guidance as developments occur. For a comprehensive understanding of this decision’s impact and potential actions, we recommend consulting with your contacts at Allen & Overy LLP.

Footnotes

<sub>1. 8 Del. C. § 141(a).
2. West Palm Beach Firefighters’ Pension Fund v. Moelis & Company, C.A. No. 2021-0309-JTL (Del. Ch. Feb. 23, 2024).
3. If the response to the first inquiry is in the negative, then the inquiry ends there and Section 141(a) will not apply.
4. Opinion, at 80.
5. Id. at 101.
6. Id. at 102.
7. Id. at 9.
8. Id. at 10.
9. In his rulings with respect to these provisions, Vice Chancellor Laster did indicate that these provisions could be found to be invalid if properly challenged as to their application in specific circumstances.
10. Opinion,. at 126.
11. Ace Ltd. v. Capital Re Corp., 747 A.2d 95 (Del. 1999) 
12. Paramount Communications, Inc. v. QVC Network, Inc., 637 A.2d 34 (Del. 1994)
13. Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914 (Del. 2003)
14. Opinion. at 88.
15. Id. at 87.</sub>