Delaware Court of Chancery Invalidates Common Provisions in Stockholder Agreements

With a stroke of the pen, the Delaware Court of Chancery invalidated commonplace provisions in scores of stockholder agreements relating to public corporations and likely many more relating to private corporations.  In West Palm Beach Firefighters’ Pension Fund v. Moelis & Company (“Moelis”)[1], Vice Chancellor J. Travis Laster, struck down an entire package of stockholder veto rights and held that provisions in a stockholder agreement purporting to restrict the size of the board of directors, requiring the board to recommend in favor of a stockholder nominee, requiring the board to fill any vacancy on the board with a stockholder nominee or to include a stockholder nominated director on committees of the board, are all facially invalid as a matter of Delaware law.  Vice Chancellor Laster noted that many of these provisions would have been valid if set out in the corporation’s certificate of incorporation, rather than in the stockholder agreement.

Factual Background

At the center of the case is boutique investment bank Moelis & Company and the stockholder agreement that it entered into with its eponymous founder (the “Founder”) just prior to its IPO in 2007.  The stockholder agreement gave the Founder a number of rights and protections, specifically:

• 18 veto rights over various corporate actions;[2]
• a requirement that the board size not exceed 11 members (the “Size Requirement”);
• a right to designate a majority of the 11 board members (the “Designation Right”);
• a requirement to nominate the Founder’s designees for election to the board (the “Nomination Right”);
• an obligation that the board recommend that stockholders vote to elect the Founder’s designees to the board (the “Recommendation Requirement”);
• a requirement that the Company use reasonable best efforts to enable the Founder’s designees to be elected and continue to serve on the board (the “Efforts Requirement”);
• a requirement that the board fill any vacancy in any seat previously occupied by a Founder designee with a new Founder designee (the “Vacancy Requirement”); and
• a requirement that the Board populate any committee with a number of the Founder’s designees that is proportionate to their membership on the full board (the “Committee Composition Requirement”).[3]

It was undisputed in the case that the stockholder agreement was disclosed and that stockholders who purchased shares in the IPO were on notice of the stockholder agreement entered into more than 15 years before this claim was brought.[4]

Analysis and Findings

The Court’s starting point for its analysis was §141 of the Delaware General Corporation Law (“DGCL”), which provides in pertinent part that, “the business and affairs of any corporation. . . shall be managed by or under the direction of a board of directors, except as may be otherwise provided in. . . its charter.”  Following an extensive analysis of Delaware’s DGCL §141 jurisprudence, the court enunciated a two-factor test for assessing these types of provisions: 

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?

With respect to the first factor, the court concluded that the stockholder agreement was a “prototypical” internal governance arrangement for a number of reasons, including that the stockholder agreement (i) implicated provisions that have a statutory grounding in the DGCL, (ii) was among only the corporation and its majority stockholder (and not, for example, with a commercial counterparty), (iii) addressed how corporate actors agree on exercising the corporation’s powers; (iv) did not reflect an underlying commercial exchange; (v) did not protect an underlying commercial purpose and (vi) was not terminable by the corporation.[5]

In addressing the second factor, the Court held that the veto rights, when viewed collectively, are facially invalid.  The Court stated that the veto rights go too far as they “encompass virtually everything the Board can do.”[6]   The court did not undertake a line-by-line review of the veto rights, thus leaving an open question as to whether a subset of the veto rights (or any one of them standing on their own) would have passed muster.

The Court also found that the Size Requirement, the Recommendation Requirement, the Vacancy Requirement and the Committee Composition Requirement were facially invalid as they removed from the directors in a very substantial way, the ability to candidly and honestly communicate their views on a candidate to the corporation’s stockholders and determine, when permitted by the DGCL and the charter, the composition of the Board and its committees.[7]

On the other hand, the Court held that the Designation Right, the Nomination Requirement and the Efforts Requirement are rights that shareholders are entitled to exercise independently and the mere agreement by the corporation to facilitate the exercise of these rights is not facially invalid.  However, the court noted that even these provisions could be subject to challenge on a case-by-case basis depending on the relevant facts.[8]

The Court noted that many (though likely not all) of these provisions would survived challenge had they been included in the corporation’s charter or a certificate of designation for preferred stock.[9] 

Key Takeaways

• The case only applies to corporations and does not extend, for example, to partnerships or limited liability companies organized under Delaware law.
• The case did not differentiate between listed and private companies, and the risk profile as between such companies may differ somewhat, particularly for a private company where all stockholders are party to a stockholder agreement containing the relevant governance provisions (e.g., many venture capital backed companies).
• Widespread market practice will not be viewed a defense to activities that the courts view as contrary to Delaware law.  As the court noted “[w]hen market practice meets a statute, the statute prevails.”[10]  Nor will long-standing acceptance by the corporation and its stockholders (as noted above, the stockholder agreement in this case was entered into more than 15 years ago, and disclosed in connection with Moelis’s IPO).
• The case may transform how practitioners approach governance rights in the context of an IPO, with typical veto rights and rights to board seats being included in the certificate of incorporation or a certificate of designation for preferred stock.  The case may also result in an increase in the number of companies that IPO with multiple classes of stock.
• The court did not address whether a cross-reference to the stockholder agreement would suffice under DGCL §102(d), and if so, how specific the cross-reference would need to be.
• Stockholders and corporations who are parties to stockholder agreements with a Delaware corporation should assess whether there is any action they should proactively take in response to this decision. 
• At the same time, stockholders and corporations should bear in mind that the case may still be appealed to the Delaware Supreme Court.  Cleary Gottlieb will continue to monitor any developments on this case, as well as any legislation that may be proposed in the Delaware legislature in response to the holding in this case.

[1] C.A. No. 2023-0309 (the “Opinion”).

[2] The Founder’s veto rights included: incurrence of indebtedness above a certain threshold, issuances of equity in excess of certain thresholds, M&A and investment matters, removal or appointment of any Section 16 officer, amendment of any governing documents, declaration or payment of any dividend, liquidation of the corporation or its subsidiaries, any amendment to a material contract; initiation or settling material litigation and commencing any voluntary liquidation.  Opinion at 18-19.  as these rights required the Founder’s consent before the board could authorize any of the relevant actions, the Court characterized these rights as “pre-approval rights,” rather than “veto rights,” but noted that the distinction did not affect the Court’s analysis.  Opinion at 10.)

[3] Opinion at 4-5.

[4] Opinion at 17. Note that in a separate decision (W. Palm Beach Firefighters Pension Fund v. Moelis & Co., 2024 WL 550750 (Del.Ch. Feb 12, 2024), the Court rejected the corporation’s laches defense (that the claim should have been brought sooner).

[5] Opinion at 101, 95-97.

[6] Opinion at 4, 102

[7] Opinion at 102-118, 121-124.

[8] Opinion at 119-121

[9] Opinion at 13.  The Court did not specify which of the offending provisions would, or would not, have passed muster had they been included in Moelis’s charter.

[10] Opinion at 132.

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