• Delaware Court of Chancery holds contractual waivers of fiduciary duties are facially valid when they are both narrowly tailored to authorize specific transactions and satisfy the Court’s review for reasonableness.
• Court cautions that blanket contractual waivers of claims for a breach of fiduciary duty are unlikely to survive review.
• Court will not enforce contractual waivers of claims for an intentional breach of fiduciary duty.

The Delaware Court of Chancery on May 2, 2023, in New Enterprise Associates 14, L.P. v. Rich, approved a covenant binding stockholders not to sue on a claim for breach of fiduciary duty in the context of a drag-along sale.¹ After an exhaustive discussion of various policy arguments in favor of and against a contractual waiver of the ability to pursue a claim for breach of fiduciary duty, the Court concluded that Delaware law authorizes a stockholder-specific, contractual waiver when it is narrowly tailored to apply to a specific transaction that would otherwise constitute a fiduciary breach and where the waiver satisfies a review for reasonableness. Despite affirming the contractual waiver, however, the Court held that the waiver did not bar plaintiffs’ claims in this case because, as a matter of Delaware policy, a contractual party cannot waive claims for an intentional tort, which the plaintiffs had well-pled.² The decision nonetheless provides a path for sophisticated parties to further allocate risk in transactions through such a contractual waiver.

Background³

The case arose from a recapitalization of Fugue, Inc. (the “Company”), a start-up founded in 2012 to maintain cloud security infrastructures. The plaintiffs, investment funds sponsored by venture capital firms New Enterprise Associates and Core Capital Partners (the “Funds”), invested almost $39 million in the Company through multiple financing rounds.

By 2020, after a failed sale process undertaken at the Funds’ urging and in need of growth capital, the Company pursued a recapitalization with new investors. Defendant George Rich led the investor group, along with two vehicles controlled by him (the “Lead Investors”).

Among other conditions negotiated in exchange for supporting the recapitalization, the Lead Investors entered into a voting agreement with the Company and the Funds (among others) (the “Voting Agreement”). The Voting Agreement contained a drag-along right that the Lead Investors would be entitled to exercise if eight specific criteria were met. If the drag-along right was exercised, the Funds covenanted not to sue the Lead Investors over the drag-along sale, which included a waiver of claims for breach of fiduciary duty (the “Covenant”). Specifically, the Funds committed:

“to refrain from … (ii) asserting any claim or commencing any suit (x) challenging the Sale of the Company or this Agreement or (y) alleging a breach of any fiduciary duty of the Electing Holders or any affiliate or associate thereof… in connection with the evaluation, negotiation or entry into the Sale of the Company, or the consummation of the transactions contemplated thereby.”

The recapitalization became effective on April 30, 2021. Pursuant to the Voting Agreement, Rich and defendant David Rutchik joined the CEO and two other directors on the five-person board. As a result of the recapitalization, the Lead Investors and trusts affiliated with Rutchik (the “Trusts”) together owned 39% of the Company’s voting power while the Funds declined from owning 35% of the Company’s voting power to 17%.

In late June 2021, a third party approached the Company with an acquisition offer. On July 14, 2021, two of the Company’s directors resigned, leaving only the CEO, Rich, and Rutchik on the board. On July 21, 2021, the board authorized the issuance of additional preferred stock on terms similar to the “generous” terms of the recapitalization—even though the Company already had raised $8 million and had received an indication of interest. The buyers in this new round were the Lead Investors, the Trusts, and six other entities or individuals—with over 78% of shares in the new round going to either the Lead Investors or the Trusts. After this second round, the Lead Investors and the Trusts controlled 48% of the Company’s voting power. On July 29, 2021, the Company issued large grants of incentive equity to the Company’s employees, including to the three remaining directors.

Meanwhile, the Company and the third-party acquirer proceeded with the proposed acquisition. On December 18, 2021, the board informed the Company’s stockholders of the merger. The merger closed on February 18, 2022. Three days later, the Company provided a full distribution waterfall to the Funds revealing the existence of the shares issued in the July 2021 offering and the July 2021 equity grants (together, the “Interested Transactions”). As a result of the Interested Transactions, the Lead Investors, the Trusts, and the CEO received $25.6 million in net proceeds from the merger—a portion of which proceeds the Funds claimed were diverted from the other investors in the Company. The Funds commenced this litigation.

The Court's Decision

The Court previously held in Fugue I that the Funds stated a claim for breach of fiduciary duty against Rich, Rutchik, and the CEO because, through the merger, they caused derivative claims related to the Interested Transactions to be extinguished—thus reflecting a personal benefit to themselves not shared with the other investors. As a result, the Court held in Fugue I that the derivative claims were effectively revived in the form of a post-closing direct claim against Rich, Rutchik and the CEO.⁴ In Fugue II, the Court addressed defendants’ arguments that the Funds, through the Covenant, waived any claims for breach of fiduciary duty in connection a drag-along sale. While holding that the Covenant was facially valid, the Court concluded that, as a matter of Delaware policy, the Covenant could not bar the Funds’ claims for an intentional breach of fiduciary duty.

Validity of “Fiduciary Tailoring”

Beyond the scope of this OnPoint is the Court of Chancery’s exhaustive discussion of competing policy arguments in favor of and against the ability of an individual stockholder to contract away the right to pursue a claim for breach of fiduciary duty.⁵ Ultimately adopting an individual, contractarian model of jurisprudence, the Court held that a stockholder can prospectively waive claims for breach of fiduciary duty, but that such a waiver (i) must be narrowly tailored to address a specific transaction that would constitute a breach of fiduciary duty and (ii) would still be subject to review for reasonableness.⁶

The Court concluded that the Covenant was narrowly tailored because it “applies to one of three types of transactions that qualify as a Sale of the Company” in the Voting Agreement,⁷ and the “terms of the transaction must then meet the eight specific criteria necessary to qualify as a Drag-Along Sale.”⁸

As for reasonableness, the Court followed the Delaware Supreme Court’s analysis in Manti Holdings, LLC v. Authentix Acquisition Co., in which the Supreme Court approved a contractual waiver of appraisal rights.⁹ The Court held that the following five factors from Manti were met, supporting the waiver contained in the Covenant:

(i) a written contract formed through actual consent,

(ii) a clear provision,

(iii) sophisticated stockholders who understood the provision’s implications,

(iv) the ability to reject the provision, and

(v) the presence of bargained-for consideration.

The Court nonetheless held that the Covenant did not bar the Funds’ claim for breach of fiduciary duty in its entirety. In so holding, the Court noted that Delaware policy bars contractual waivers of claims resulting from intentional torts. Because the Funds’ factual allegations supported a claim for an intentional breach of fiduciary duty, the Court held the Funds’ claims could proceed. In so holding, the Court was keen to contrast the Funds’ claims with those based either on recklessness, which would implicate the duty of care, or on the good faith belief that a self-interested transaction was in the best interests of the Company; in either case, the Court noted that the Covenant would likely foreclose such claims.

Key Takeaways

The ability to waive contractually claims for breach of fiduciary duty provides another means for sophisticated parties to allocate risk in a transaction—much like parties have had the ability to bar claims for extracontractual fraud and to waive appraisal rights.

Nonetheless, the Court’s decision should not be read too far. The Court’s analysis is grounded on an individual, contractarian theory of corporate law—one unlikely to extend to less sophisticated investors, to the stockholder base as a whole, or to situations that could be coercive. Indeed, the Court offered several scenarios when a provision like the Covenant “would face deep skepticism”:

• An agreement binding a retail stockholder.

• An employee stock grant.

• A dividend reinvestment plan.

• An employee stock-compensation plan.

• A letter of transmittal in a merger transaction.

• A transaction that offered an election between base consideration and incremental consideration plus a covenant not to sue.¹⁰

As to sophisticated parties seeking to contractually waive claims for fiduciary breaches, care must still be taken to ensure that:

• The waiver is drafted in clear, unambiguous language in which the triggers for, and effect of, the waiver are unmistakable.

• The party granting the waiver is sophisticated and could negotiate for or reject the provision.

¹ New Enter. Assocs. 14, L.P., et al. v. George S. Rich, Sr., et al., -- A.3d --, 2023 WL 3195927 (Del. Ch. May 2, 2023) (“Fugue II”).

² See New Enter. Assocs. 14, L.P., et al. v. George S. Rich, Sr., et al., -- A.3d --, 2023 WL 2417271 (Del. Ch. Mar. 9, 2023) (“Fugue I”).

³ The background is taken from the Court’s description in Fugue I and Fugue II of the allegations in the complaint.

⁴ Fugue I, 2023 WL 2417271, at *28-42.

⁵ See Fugue II, 2023 WL 3195927, at *11-50.

⁶ This is not the first time that the Court of Chancery has approved a contractual waiver of claims for breach of fiduciary duty. As the Court noted in its decision, Vice Chancellor Slights previously held in a transcript decision that “a bargained-for covenant not to sue barred claims for breach of fiduciary duty. . . .” Fugue II, 2023 WL 3195927, at *49-50 (citing In re Altor Bioscience Corp., C.A. No. 2017-0466-JRS (Del. Ch. May 15, 2019) (TRANSCRIPT)).

⁷ Defined in the Voting Agreement as either (i) a sale of equity in which the stockholders sell shares representing more than 50% of the Company’s outstanding voting power, (ii) a merger in which the Company’s pre-merger stockholders end up holding less than 50% of the Company’s outstanding voting power, or (iii) a sale of all or substantially all of the Company’s assets. Fugue II, 2023 WL 3195927, at *9.

⁸ Fugue II, 2023 WL 3195927, at *51.

⁹ Manti Hldgs., LLC v. Authentix Acquisition Co., 261 A.3d 1199 (Del. 2021).

¹⁰ Fugue II, 2023 WL 3195927, at *52.