Key Takeaways

• The Delaware Court of Chancery held that stockholder governance rights that restrict the ability of the board of directors to manage or direct the business and affairs of a corporation are facially invalid under Delaware law unless such rights are included in the corporation’s Certificate of Incorporation.

• Stockholders and corporations that have existing stockholder agreements with similar provisions should consider whether the charter of such corporations should be proactively amended to include such provisions, and should ensure there are no inconsistent provisions in their By-laws.

• The ruling only applies to Delaware corporations and is not applicable to Delaware limited liability companies or limited partnerships that have similar provisions.

The Delaware Court of Chancery (the “Court”) recently published a lengthy opinion in West Palm Beach Firefighters’ Pension Fund v. Moelis & Co., C.A. No. 2023-0309-JTL (Del. Ch. February 23, 2024), in which the court invalidated a number of common provisions in a stockholder agreement on the basis that such rights impeded the ability of the board of directors (the “Board”) to manage and direct the business and affairs of Moelis & Co. (the “Company”). The Court’s opinion bears great significance, as many stockholder agreements contain similar provisions, and will likely transform the approach that practitioners take with respect to drafting stockholder governance rights.

In the relevant case, the Company, a boutique investment bank, entered into a stockholder agreement with its founder and CEO (the “Founder”) shortly before the Company’s IPO. The stockholder agreement granted the Founder a broad range of rights and protections, including:

• The “Pre-Approval Requirements,” which obligated the Board to obtain the consent of the Founder prior to the Board authorizing 18 different types of corporate actions, including, but not limited to:
  • Issuing securities
  • Incurring debt
  • Issuing common stock and preferred stock
  • Removing certain officers of the Company
  • Adopting a budget
  • Declaring dividends
  • Allowing the Company to merge or sell substantially all of its assets
  • Entering into material contracts

• The “Board Composition Requirements,” which included:
  • A “Size Requirement” requiring the Board to use its best efforts to maintain the size of the Board at no more than 11 seats
  • A “Designation Right” requiring the Board to seek the Founder’s consent to name designees equal to a majority of the Board
  • A “Nomination Requirement requiring the Board to nominate the Founder’s designees as candidates for election to the Board
  • A “Vacancy Requirement” requiring the Board to fill any vacancy occupied by a Founder designee with a new Founder designee
  • A “Recommendation Requirement” requiring the Board to recommend that the shareholders vote in favor of the Founder’s designees

• A “Committee Composition Requirement” requiring the Board to include a proportionate number of Founder designees on each Board committee.

The plaintiff shareholder argued that the Founder’s governance rights in the stockholder agreement violated Delaware General Corporation Law (“DGCL”) Section 141(a), which states “[t]he business and affairs of every corporation organized under this chapter shall be managed by or under the direction of the board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation.”

The Court held that all of the Pre-Approval Requirements, certain of the Board Composition Requirements (the Size Requirement, the Recommendation Requirement, and the Vacancy Requirement) and the Committee Composition Requirement were facially invalid under DGCL Section 141(a). In analyzing the governance rights given to the Founder, the Court relied on the test espoused in Abercrombie v. Davies, 123 A.2d 893 (Del. Ch. 1956), which asked whether the provisions had the effect of removing the directors in a substantial way from their duty to use their own best judgment on management matters, or if they tended to limit in a substantial way the freedom of director decisions on matters of management policy.

Applying the test used in Abercrombie, the Court found the Pre-Approval Requirements, viewed collectively, to be facially invalid as they “encompass virtually everything the Board can do.” Interestingly, the Court did not address whether any of the Pre-Approval Requirements on an individual basis could be valid, leaving open the question as to whether a smaller package of veto rights or certain individual veto rights would be permissible in a stockholder agreement entered into by a Delaware corporation.

In finding the Recommendation Requirement to be facially invalid under DGCL Section 141(a), the Court noted that such requirement interferes with the Board’s ability to communicate to the Company’s stockholders the directors’ honest views of a prospective Board candidate and their best judgement as to who should serve as a director. The Court found the Vacancy Requirement to be inconsistent with the Company’s Certificate of Incorporation, which provided the Board with exclusive power to fill board vacancies. In addition, the Court found the Size Requirement to interfere with the Company’s Certificate of Incorporation and By-laws, which required the size of the Board of Directors to be established by the Board. Finally, the Court concluded that the Committee Representation Requirement was inconsistent with DGCL Section 141(c) and the Company’s By-laws, which provided for the Board to designate and determine the composition of any committees.

On the other hand, the Court did find that several of the Board Compensation Requirements (the Designation Right, the Nomination Requirement, and the Efforts Requirement) were ministerial in nature and not unduly restrictive on the Board and, therefore, were not facially invalid.

Considerations Moving Forward

As noted above, this ruling only applies to Delaware corporations and does not have any effect on the governance rights for Delaware limited liability companies and limited partnerships.

Moving forward, companies granting governance rights to stockholders should consider doing so in corporate charters rather than in contractual agreements. The Court suggested that the Founder could have accomplished similar intended outcomes by including the challenged provisions in the Company’s Certificate of Incorporation or a preferred stock certificate of designation. As an example, the Court suggested the Company could have issued a “golden share” of preferred stock and attached the governance rights to the “golden share” in the certificate of designation, although the Court noted that any such provisions which conflicted with a mandatory provision in the DGCL, even if included in the Certificate of Incorporation or certificate of designation, would be invalid.

As many existing stockholder agreements contain similar provisions to the provisions in the stockholder agreement in Moelis, companies and their stockholders should consider making changes to such stockholder agreements to the extent such agreements contain provisions that substantially impede a board’s ability to manage the business and affairs of a company or conflict with DGCL, or the company’s Certificate of Incorporation.

Corporations and stockholders should keep in mind that it is possible that the Moelis decision could be appealed. In addition, there are several similar cases currently pending. Therefore, the Moelis ruling is likely not the final say on the topic of stockholder governance rights in Delaware. Hinckley Allen will continue to monitor any new developments relating to this case and will provide any relevant updates.