There are generally two ways you can control a corporation.  One is by owning a majority of the stock, in which case you control the board of directors.  The other is to secure control contractually, through agreements and charter provisions that provide protections such as board representation or vetos over major transactions.  But what happens when those contractual and charter provisions interfere with the statutory authority of a board of directors to manage a company’s affairs as mandated by state corporate law?  A recent Delaware Chancery Court decision in West Palm Beach Firefighters’ Pension Fund v. Moelis & Co. invalidated provisions of a stockholders agreement because they constituted an impermissible delegation of the board’s managerial authority in contravention of Delaware law. The decision throws into question the enforceability of corporate governance provisions routinely included in stockholder agreements, investor rights agreements and voting agreements.

Statutory Authority of Board of Directors

Section 141(a) of the Delaware General Corporation Law (the “DGCL”) provides that:

“the business and affairs of every [Delaware] corporation … shall be managed by or under the direction of a board of directors, except as may be otherwise provided [under the DGCL] or in its certificate of incorporation.”

Section 141(c)(2) empowers the board to designate one or more committees and to determine the composition of those committees.

The Moelis Stockholders Agreement

Just before its IPO, boutique global investment bank Moelis & Co. entered into a stockholders agreement with its founder, CEO and principal stockholder, Ken Moelis, and three of his affiliates.  The agreement gave Mr. Moelis three types of broad governance rights, which the Court categorized as Pre-Approval Requirements, Board Composition Provisions and a Committee Composition Provision.

The Pre-Approval Requirements mandated that the company obtain Moelis’ prior written consent before engaging in any of eighteen different significant actions, including issuing stock, incurring debt, entering into a new line of business, appointing or removing an officer, amending the certificate of incorporation or by-laws, adopting a budget, declaring a dividend or merging or selling the company or all or substantially all of its assets.

Under the Board Composition Provisions, the board was contractually obligated to maintain its size at not more than eleven seats, nominate Moelis’ designees which were to constitute a majority, recommend those nominees to the stockholders for a vote and fill vacancies of Moelis seats with new Moelis designees.

The Committee Composition Provision gave Moelis the right to have a proportionate number of his designees serve on any board committee.

The Stockholder Challenge

A Moelis stockholder sued the Company, claiming that the challenged provisions violated Sections 141(a) and 141(c)(2) of the DGCL. The plaintiff pointed to Delaware law precedent under the seminal Abercrombie case that a governance restriction in a contract (as opposed to the certificate of incorporation) is invalid if it:

“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…”

The stockholder argued that the challenged provisions fail the Abercrombie test.  The Pre-Approval Requirements mean that Moelis determines what action the board could take, meaning the directors can’t exercise their own judgment.  The Board Composition Provisions prevent the directors from using independent judgment when determining board size, selecting nominees and filling vacancies.  The Committee Composition Provision prevents the directors from exercising their judgment when populating committees.

The company’s defense centered around the sanctity of contracts and the notion that many contracts necessarily constrain a board’s freedom of action.  For example, exclusive supply agreements deny a board the freedom to contract with another party.  A credit agreement typically contains negative covenants that constrain a board’s freedom of action, such as declaring dividends or redeeming shares.  No one would suggest that either of these agreements violates Section 141(a). 

The Court’s Decision

The Court distinguished between external commercial agreements, which do not raise Section 141(a) concerns, and invalid restrictions on board authority, which do.

In its analysis, the Court created a two-pronged test to determine the validity of stockholders agreements under Section 141(a).  Under the first prong, a determination is made as to whether or not a contractual provision is part of an internal governance arrangement.  If it isn’t, Section 141(a) does not apply and the inquiry ends there.  If it is, the second prong is triggered, which is whether the challenged provision constitutes a restriction on board authority and therefore violates Section 141(a).

The Court stated that the challenged provisions in this case “look like something a law professor dreamed up for students to use as a prototypical Section 141(a) violation” and that they resemble the type of governance rights associated with preferred stock. With limited exceptions, they were drafted to bind the board, not the company.  No one would mistake them for a supply agreement, credit agreement or other commercial contract.

Once the Court determined that the challenged provisions were part of an internal governance arrangement and thus subject to Section 141(a), the question then became whether they violate the Abercrombie test by substantially removing from directors their duty to use their own best judgment on management matters or substantially limiting the freedom of director decisions on management.

The Court found the Pre-Approval Requirements, taken as a whole, fail the Abercrombie test because they force the Board to obtain Moelis’ prior written consent before taking virtually any meaningful action.  The directors can only manage the company to the extent Moelis gives them permission to do so. Hence, the Pre-Approval Requirements, taken as a whole, violate Section 141(a).

As to the Board Composition Provisions, the Court determined that three of them also violate Section 141(a): the recommendation requirement improperly compels the board to recommend Moelis’ designees for election; the vacancy requirement improperly compels the board to fill a Moelis seat vacancy with another Moelis designee; and the board size requirement improperly enables Moelis to prevent the board from increasing the number of board seats beyond eleven.

Finally, the Court found that the Committee Composition Provision violates both Section 141(a) and Section 141(c)(2) because determining the composition of committees falls within the Board’s authority and a stockholder cannot determine who serves on a committee.

The Moelis decision will likely shine a light on the validity of stockholders agreements, investor rights agreements, voting agreements and other agreements granting similar governance rights to stockholders, and could spark a flood of litigation challenging these types of arrangements.

In reaction to the expansive use of governance rights in stockholder agreements, the Court stated in a footnote that “greater statutory guidance may be beneficial”.  The Delaware State Bar Association’s ears may have been ringing.  On March 28, 2024, the Council of the Corporation Law Section of the DSBA approved a proposed amendment to the DGCL which would set forth a non-exclusive list of provisions that a corporation may include in a stockholders’ agreement, including without limitation restricting or prohibiting itself from taking actions specified in the contract; requiring the approval or consent of one or more persons or bodies before the corporation may take actions specified in the contract; and covenanting that the corporation will take, or refrain from taking, actions specified in the contract. The proposed amendments must be approved by the DSBA’s Corporation Law Section and Executive Committee at meetings expected to be held in April, and then submitted to Delaware’s General Assembly. If adopted by the General Assembly and signed into law by the governor, the amendments would generally become effective August 1, 2024.

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