In holding that certain provisions within the stockholder agreement of a Delaware corporation are invalid under the Delaware General Corporation Law (DGCL), the Delaware Court of Chancery has created a framework for evaluating whether an agreement impermissibly restricts the authority and duty of directors to manage the business and affairs of the corporation in their best judgment. While the case, West Palm Beach Firefighters’ Pension Fund v. Moelis & Co., C.A. No. 2023-0309-JTL (Del. Ch. February 23, 2024), may be appealed by the defendant, the opinion provides important guidance for corporate planners when crafting agreements pertaining to internal governance of a Delaware corporation.

IN DEPTH

THE FACTS

Prior to Moelis & Company, a Delaware corporation (the Company), going public in an initial public offering, the Company’s founder, CEO and chairman of the board (the Founder), along with certain affiliates, entered into a stockholder agreement (Stockholder Agreement) with the Company, which was fully disclosed to the Company’s investors. The Stockholder Agreement granted the Founder (directly and indirectly) expansive rights pertaining to the management and governance of the Company, which the Court described as the Pre-Approval Requirements, Board Composition Provisions and Committee Composition Provision.

Pre-Approval Requirements. These obligate the Company’s board of directors (the Board) to obtain the Founder’s prior written consent before taking certain actions, which encompass virtually everything the Board can do, including, inter alia, issuing securities, incurring debt, amending the certificate of incorporation or bylaws, removing or appointing senior officers, adopting a budget and business plan, declaring dividends, and causing the Company to merge, sell substantially all assets or dissolve.

Board Composition Provisions. These ensure that the Founder can select a majority of the directors through the following contractual obligations:

• The Company must use best efforts to maintain the size of the Board at no more than 11 seats unless the Founder consents to an increase in the number of directors (Size Requirement).
• The Founder can name designees equal to a majority of the Board seats (Designation Right).
• The Board must nominate the Founder’s designees as candidates for election (Nomination Requirement).
• The Board must recommend that stockholders vote in favor of the Founder’s designees (Recommendation Requirement).
• The Company must use reasonable efforts to enable the Founder’s designees to be elected and continue to serve (Efforts Requirement).
• The Board must fill any vacancy in a seat occupied by a Founder designee with a new Founder designee (Vacancy Requirement).

Committee Composition Provision. This forces the Board to appoint to any committee such number of the Founder’s designees proportionate to the number of the Founder’s designees on the full Board. The Board cannot create a committee with a different number of Founder designees or an independent committee without any Founder designees unless the Founder consents.

The plaintiff, a Company stockholder, claimed that these provisions violate Sections 141(a) and 141(c) of the DGCL. The plaintiff’s claim was based on Delaware precedent holding that a governance restriction in an agreement (as opposed to the corporation’s certificate of incorporation) is invalid when it, either directly or indirectly, has “the effect of removing from directors in a very substantial way their duty to use their own best judgment on management matters” or “tends to limit in a substantial way the freedom of director decisions on matters of management policy.” (Referred to as the Abercrombie test by the Court.)

THE COURT OF CHANCERY’S ANALYTICAL FRAMEWORK

Based on Sections 141(a) and 141(c) and Delaware precedent, the Court created a two-step framework under which challenges to an agreement should be analyzed for compliance with Section 141(a). First, the Court must determine whether the challenged provision is part of an internal governance arrangement. If not, then the inquiry ends. If so, then the Court moves to the second step – the Abercrombie test – to determine whether the provision imposes a restriction that violates Section 141(a).

First Step: Is the Provision Part of the Company’s Internal Governance Arrangement?

Section 141(a) polices external arrangements that seek to implement internal restrictions on a board of directors’ ability to exercise its power and fulfill its duties. Determining whether an external contract establishes a governance arrangement (as opposed to a commercial arrangement) is a matter of degree, but the Court provided the following seven factors to consider:

• Governance agreements frequently have a statutory grounding in the DGCL. For example, stockholder agreements are grounded in Section 218, merger agreements in Section 251, officer employment agreements in Section 142 and asset sale agreements in Section 271.
• The corporation’s counterparties in a governance agreement hold roles as intra-corporate actors (i.e., officers, directors, stockholders or their affiliates), whereas a standard commercial counterparty might be a supplier, customer or service provider.
• The challenged provision seeks to specify the terms on which intra-corporate actors can authorize the corporation’s exercise of its corporate power, such as by requiring or prohibiting voting in a certain way or forbidding actions that directors could otherwise take.
• Unlike a commercial contract, a governance agreement does not readily reveal an underlying commercial exchange. The point of a governance arrangement is the governance, whereas in a commercial arrangement there is a clearer exchange of consideration.
• The relationship between the contractual restrictions and a commercial purpose. Features in a commercial arrangement that touch on governance often are intended to protect the underlying commercial transaction, whereas in a governance arrangement, the governance rights are the point.
• The presumptive remedy for breach. In a commercial agreement, the presumptive remedy will be damages tied to the commercial bargain; whereas a governance arrangement will involve control rights, so the presumptive remedy will be equitable relief enforcing the right.
• The duration of the contract and the corporation’s ability to terminate it. A commercial agreement is more likely terminable or has a limited duration, and a governance arrangement is more likely to be enduring and the corporation lacks the ability to freely terminate.

Second Step: Does the Challenged Provision Improperly Restrict the Board?

If the Court determines that the challenged provision appears in a contract is part of the corporation’s governance arrangement, the Court will then apply the Abercrombie test to determine validity under Section 141(a). This requires the Court to assess whether the provision, directly or indirectly, (i) has the effect of removing from the directors in a very substantial way their duty to use their own best judgment on management matters or (ii) tends to limit in a substantial way the freedom of director decisions on matters of management policy.

Delaware courts have invalidated direct board-level constraints (i.e., purports to bind the board or individual directors, as in “the board shall” or “the board shall not”) and have invalidated direct company-level constraints (i.e., purports to bind the company, as in “the company shall” or “the company shall not,” where the issue requires a board decision). The Court also explained that, albeit less frequently, Delaware courts have invalidated indirect board-level constraints (i.e., imposes a sufficiently onerous consequence on the board or individual directors for taking or not taking the specified action) and indirect company-level constraints (i.e., imposes a sufficiently onerous consequence on the company for taking or not taking an action that requires a board decision). But in each case, the constraint only applies to governance arrangements – a constraint that appears in a non-governance arrangement does not give rise to a Section 141(a) issue.

Specifically with respect to stockholder agreements (which are permitted by Section 218(c) of the DGCL – though the Court in dicta suggested that Section 218 should be amended to provide more clarity as to what stockholder agreements can accomplish), the Court presented a simple test for determining when a provision is not subject to Section 141(a): Does the contractual provision address an action that an individual stockholder or a group of stockholders collectively could take (e.g., exercising their voting rights)? If yes, then stockholders can contract over that action in advance without implicating Section 141(a). However, if the provision purports to enable stockholders to manage the business and affairs of a corporation, it is invalid – that specific authorization must come from either the DGCL or the certificate of incorporation.

THE HOLDING

Utilizing this framework, the Court concluded that the challenged provisions in the Stockholder Agreement were prototypical governance provisions in a prototypical governance agreement and were therefore part of the Company’s internal governance arrangement. The Court held that the Pre-Approval Requirements, Recommendation Requirement, Vacancy Requirement, Size Requirement and Committee Composition Provision were facially invalid. The Court noted, however, that if they were contained in the Company’s certificate of incorporation, they could be valid (though with some limitations, since a certificate of incorporation cannot override a mandatory feature of the DGCL and even if in the certificate of incorporation, it would remain subject to an as-applied challenge under equitable principles).

The Pre-Approval Requirements are facially invalid because they require the Founder’s prior approval before the Board can act on virtually every important management matter, effectively rendering the Board an advisory body and likely having a chilling effect on the matters the Board would potentially present to the Founder for approval.

The Recommendation Requirement, Vacancy Requirement, Size Requirement and Committee Composition Provision are facially invalid because each remove from the directors in a very substantial way their duty to use their own best judgment on a management matter (i.e., who should serve as a director, the size of the Board and who should serve on a committee).

On the other hand, the Court held that the Designation Right (which enables the Founder to specify individuals as potential candidates for election), the Nomination Right (which enables a Founder nominee to stand for election), and the Efforts Requirement (which requires the Company to take reasonable actions to cause the Founder’s designees to be elected to the Board, such as by including information about them in the Company’s proxy statement) are not facially invalid. None of these provisions imposed a restriction on the Board’s ability to exercise its management authority and fulfill its duties. While not facially invalid, these provisions could still be subject to an as-applied challenge if such provisions are applied inequitably – every corporate action is twice tested, first for technical compliance with the DGCL and the corporation’s governing documents and second for compliance with equity.

KEY TAKEAWAYS

• While Moelis may be appealed to the Delaware Supreme Court, it provides guidance pertaining to the validity of provisions contained in many stockholder agreements and other governance arrangements (such as settlement agreements resolving proxy contests with activist investors) that purport to restrict the ability of a Delaware corporation’s board of directors to fully and freely exercise their authority to manage the corporation in accordance with their fiduciary duties.
• The provisions at issue in Moelis were held to be facially invalid but the Court suggested that many of the provisions could have been valid if instead contained in the Company’s certificate of incorporation – Section 141(a) allows for a certificate of incorporation to modify the power of the board to manage the business and affairs of the corporation. Parties can therefore include governance provisions in the corporation’s certificate of incorporation – with the caveat that even provisions in a certificate of incorporation cannot override a mandatory feature of the DGCL. Further, Section 102(d) of the DGCL provides that any certificate of incorporation may be made dependent upon facts ascertainable outside such certificate, provided that the manner in which such facts shall operate upon the certificate of incorporation is clearly and explicitly set forth therein. Thus, another option would be for parties to include such governance provisions in a separate agreement and then incorporate by reference those governance provisions into the certificate of incorporation. We note, however, that it remains to be seen what level of specificity that would be required for such incorporation by reference to satisfy the Section 141(a) issues raised in Moelis.
• Under Delaware law, all corporate actions are twice tested: once for legal validity (such as for compliance with Section 141(a)) and second for equity. The Court invalidated the challenged provisions for failure to comply with the DGCL – they were not legally valid provisions. The Court therefore did not need to address whether the valid provisions (or the invalidated provisions had they been legally valid) would satisfy the second part of the test. This leaves open the possibility for challenges to such provisions on equitable grounds. For example, even if a governance provision is valid (e.g., a provision included in the certificate of incorporation) it could be unenforceable if applied inequitably.

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