The Delaware Court of Chancery is striking back against “new wave” stockholder agreements, which feature stockholder preapproval rights and board restrictions, rather than covenants among stockholders regarding traditional stockholder rights.

At the core of this challenge is Section 141(a) of the Delaware General Corporation Law (DGCL), which provides, in relevant part, that “the business and affairs of every corporation organized [in Delaware] 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 charter.”[1]

Factual Background

In West Palm Beach Firefighters’ Pension Fund v. Moelis & Company,[2] a stockholder of Moelis & Co., a public company, challenged provisions of the corporation’s stockholder agreement, which provided Moelis & Co.’s founder, CEO and Chairman, Ken Moelis, with expansive preapproval rights with respect to 18 key corporate decisions, including decisions regarding dividend payments, senior officer appointments, financing, stock issuances and litigation. Additionally, the stockholder agreement provided that (i) the board was required to nominate and recommend individuals designated by Ken Moelis to fill a majority of the board seats, and (ii) the board was required to appoint a majority of Ken Moelis’ designees to all board committees.

In other words, in nearly all instances, the board could act only if Ken Moelis approved the board’s proposed actions in advance.

The plaintiff stockholder argued that such provisions effectively eliminated the board’s authority to manage the corporation, in violation of Section 141(a).

Legal Analysis

The court established a two-prong test in determining (i) whether Section 141(a) applies and, (ii) whether the challenged provision violates Section 141(a).

First, in determining whether Section 141(a) applies, the court will consider whether “the challenged provision constitutes part of the corporation’s internal governance arrangement.”[3] If the answer is “yes,” the challenged provision is subject to Section 141(a), and the court will consider whether the challenged provision improperly restricts the board’s authority.

Second, in determining whether the challenged provision of the stockholder agreement improperly restricts the board’s authority, the court applied the Abercrombie test, which states that “governance restrictions violate Section 141(a) when they have the effect of removing from directors, in a very substantial way, their duty to use their own best judgement on management matters or tend to limit, in a substantial way, the freedom of director decisions on matters of management policy.”[4]

The court found that the challenged provisions were “prototypical governance provisions in a prototypical governance agreement,” and were therefore part of the Company’s internal governance arrangement.[5] The court also rejected the company’s argument that contracts “necessarily constrain a board’s freedom of action” and distinguished between external commercial contracts that may place restrictions on the board and corporation and internal corporate governance agreements.[6]

The court found that substantially all the challenged provisions in the corporation’s stockholder agreement failed the Abercrombie test. Specifically, the preapproval requirements forced the board “to obtain Moelis’ prior written consent before taking virtually any meaningful action.”[7] Additionally, the board composition provisions and the committee composition provisions controlled board action.[8] Each of these provisions served to restrict the board from effectively exercising its judgment in managing the corporation as intended under Section 141(a), and therefore, those provisions were invalid.

The court made a clear distinction between contractual arrangements among stockholders and rights granted to stockholders pursuant to a corporation’s charter. Moelis does not prevent corporations from providing certain rights to stockholders by granting such rights in the charter. For instance, a corporation may grant certain voting and appointment rights to holders of preferred stock in the corporation’s charter. In each case, such matters would not be subject to scrutiny under Section 141(a), provided the charter provisions do not violate a mandatory provision of DGCL.[9]

Key Takeaways

• Provisions in stockholder agreements that restrict the authority of the board are subject to scrutiny under Section 141(a) of the DGCL.
• A corporation should review its stockholder agreement with legal counsel to determine whether the stockholder agreement restrict the board’s ability to act, and should consider amending such agreements to ensure that the desired arrangement is enforceable.
• A corporation that desires to grant pre-approval or designation rights affecting its board of directors should grant such rights in its charter, not in a stockholder agreement.
• Corporations may see an increase in stockholder litigation challenging the validity of stockholder agreements or similarly restrictive documents based on this decision.

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