The ruling calls into question the enforceability of common provisions contained in private and public company stockholder agreements.

TAKEAWAYS

• The Court invalidated certain governance rights in stockholder agreements because they deprived the board of significant statutorily mandated authority.
• Many of the invalidated control rights could have been properly effectuated by including them in the company’s certificate of incorporation.
• Corporations and stockholders alike should review existing agreements with similar provisions to determine if changes are necessary.

Last month, the Delaware Court of Chancery issued a strong reminder that (1) when prevalent market practice is pitted against statutory law, it is the statute that will prevail in Delaware courts, and (2) the bedrock of Delaware law is that the board of directors manages the business and affairs of a corporation, not the stockholders.

For years, stockholder agreements between a company and its stockholders have been common for private and public companies at all stages. These agreements have provided consent, information and other rights that result in founders and significant stockholders being able to exert influence or control over corporate actions.

On February 23, 2024, in West Palm Beach Firefighters’ Pension v. Moelis & Co., the Court concluded that many of the commonly used stockholder control provisions in the stockholder agreement between Moelis & Company (the “Company”) and its founder, CEO and board chairman Ken Moelis, were facially invalid under Section 141(a) of the Delaware General Corporation Law (DGCL). With the ruling, the Court is likely to change market practice.

Section 141(a) of the DGCL states that “the business and affairs of every corporation organized under this chapter 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.” Based on a “plain English” reading of Section 141(a) of the DGCL, the Court determined that the control provisions of the stockholder agreement between the Company and Mr. Moelis were invalid because they deprived the board of a significant portion of their authority and were not in the company’s certificate of incorporation.

In the case, the plaintiff challenged the validity of certain provisions in the stockholder agreement, which provided Mr. Moelis with various governance-related rights in his favor. The Company’s board was obligated to obtain Mr. Moelis’ prior written consent before taking 18 different categories of actions (the “Pre-Approval Requirements”). The agreement also required the board to: (1) allow Mr. Moelis to name designees equal to a majority of board seats, nominate those designees and fill vacancies in those seats with new designees, (2) maintain the board size at not more than 11 directors, (3) recommend a vote in favor of those designees to company stockholders, and (4) use reasonable efforts to ensure such designees are elected and continue to serve (collectively, the “Board Composition Provisions”).

The Court engaged in an exhaustive 133-page analysis assessing decades of Section 141(a) case law to establish that the jurisprudence has provided a “clear rule” that if a provision in a stockholder agreement is an internal governance arrangement, then Section 141(a) of the DGCL applies. The Court acknowledged commercial arrangements would not necessarily be subject to Section 141(a) analysis and offered a seven-factor test to determine whether an agreement is a commercial contract or internal governance arrangement. These factors consider various contractual features, such as the presence of intra-corporate actors, the presumptive remedy for breach, the ability of the corporation to terminate the contract, and if the agreement has a statutory grounding. Here, the Court determined that the stockholder agreement in question was a “prototype” for what an internal governance contract looks like. Once that was established, the Court ruled that stockholder control rights violate Section 141(a) of the DGCL when their effect is a very substantial removal of the directors’ ability to use their own best judgment or a tendency to limit the directors’ freedom to make decisions on management matters.

While this opinion calls into question the use of a commonplace market tool to provide stockholders with additional control, it is equally important to note what this decision did not do. The plaintiff challenged the Pre-Approval Requirements individually and collectively. The Court determined these requirements were invalid only on the collective basis, noting specifically that these rights go too far when “taken together.” Whether similar rights, taken individually, may withstand a facial challenge remains to be seen. Furthermore, the Court acknowledged that these arrangements could be structured in ways that are likely to withstand challenge under Delaware law, such as incorporating stockholder rights into the certificate of incorporation or in a certificate of designation for preferred stock. In other words, if implemented properly in a company’s organizational documents, the stockholder control rights at issue in this case would not have been tested under Section 141(a) of the DGCL.

It is unclear whether this decision will be reviewed by the Delaware Supreme Court. For now, it is prudent for market participants to (1) review similar arrangements, particularly those involving restrictions on the board’s ability to exercise its own judgment on board size or composition, appointing directors, filling vacant board seats and designating members of committees, (2) consider the implications for their stockholder arrangements, and (3) determine whether to make changes as a result of this opinion.

We will be monitoring future developments on the topic and any appeal activity in the case.

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