Delaware Court of Chancery Imposes Limits on Internal Governance Arrangements through Stockholder Agreements

In West Palm Beach Firefighters’ Pension Fund v. Moelis & Company, C.A. No. 2023-0309-JTL (Del. Ch. Feb. 23, 2024), the Delaware Court of Chancery held that certain provisions in a stockholder agreement violated Section 141(a) of the General Corporation Law of the State of Delaware (the DGCL). Section 141(a) is viewed as a bedrock of the DGCL and 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.”

After years of successfully operating Moelis & Company as a global investment bank, its founder, Ken Moelis, entered into a stockholder agreement with the company one day before its initial public offering. The plaintiff, a pension fund and owner of the company’s publicly traded Class A stock, brought this action challenging whether the stockholder agreement was permissible under Section 141(a) because it removed from the company’s directors their duty to use their own best judgment on management matters.

As an initial matter, the Court acknowledged that corporate planners regularly implement stockholder agreements to impose veto rights and other restrictions on corporate action. The stockholder agreement here contained three categories of governance restrictions: (i) the “Pre-Approval Requirements”, pursuant to which the company’s board of directors (the Board) had to obtain Moelis’ prior written consent before taking 18 different categories of actions; (ii) the “Board Composition Provisions” to ensure that Moelis could select a majority of the Board’s members; and (iii) the “Committee Composition Provision” giving Moelis the right to have a proportionate number of designees serve on any committee of the Board.

In a wide-ranging opinion that considered the history of Delaware’s corporation law and decisions addressing Section 141(a), the Court wrote that the Section 141(a) inquiry involves two elements. First, a court must determine whether the challenged provision is part of an internal governance arrangement. If not, then the inquiry ends. If it does qualify as such an arrangement, the court must apply the Abercrombie v. Davies test to determine whether the provision imposes a restriction that violates Section 141(a).

Noting that “stockholder agreements are fertile ground for Section 141(a) violations,” the Court described a number of factors for consideration when determining whether a contract constitutes an internal governance arrangement: (i) the extent to which the contract has statutory grounding in a section of the DGCL (stockholder agreements are grounded in Section 218(c) and (d)); (ii) whether the corporation’s counterparties in a governance agreement hold roles as intra-corporate actors; (iii) whether the challenged provisions seek to specify the terms on which intra-corporate actors can authorize the corporation’s exercise of its corporate power; (iv) whether the contract reveals an underlying commercial exchange; (v) the relationship between the contractual restrictions and a commercial purpose; (vi) the remedy for breach; and (vii) the duration of the contract and the corporation’s ability to terminate it. The Court then reviewed the foregoing factors in the context of the stockholder agreement entered into by Moelis and explained that, “as prototypical governance provisions in a prototypical governance agreement,” the stockholder agreement was part of the company’s internal governance arrangement.

Proceeding to the next step of its analysis, the Court applied the Abercrombie test to consider whether the challenged provisions had the effect of removing from the directors in a very substantial way their duty to use their own best judgment on management matters or limited in a substantial way the freedom of director decisions on management policy. The Court evaluated the Pre-Approval Requirements, which required the written consent of Moelis before a number of Board actions including, among other things, incurrence of indebtedness above certain thresholds, issuance of equity or adoption of stockholder rights plans, appointment of officers, entry into material contracts, approval of budgets and entry into new lines of business. The Court determined that the Pre-Approval Requirements were facially invalid under the Abercrombie test, explaining that they were so all-encompassing as to render the Board an advisory body and removed from the directors in a very substantial way their duty to use their own best judgment on virtually every management matter.

Next, the Court evaluated the Board Composition Provisions, which included a “Size Requirement” (limiting the number of directors to eleven), a “Designation Right” (entitling Moelis to fill a majority of the Board seats), a “Nomination Requirement” (requiring the Board to nominate Moelis’ designees as candidates for election), a “Recommendation Requirement” (requiring the Board to recommend that stockholders vote in favor of Moelis’ designees), an “Efforts Requirement” (providing that the Board must use reasonable efforts to enable Moelis’ designees to be elected), and a “Vacancy Requirement” (stating that the Board must fill any vacancy in a seat occupied by a Moelis designee with a new Moelis designee). The Court held that, while the Recommendation Requirement, the Vacancy Requirement and the Size Requirement were facially invalid under Abercrombie, the Designation Right, the Nomination Right and the Efforts Requirement could operate legitimately without infringing on Section 141(a) of the DGCL. Lastly, the Court held that the Committee Composition Provision was invalid under both Section 141(a) and Section 141(c)(2) of the DGCL, which empowers the boards of Delaware corporations to determine the composition of committees.

In concluding its opinion, the Court recognized that adoption of a stockholder agreement containing governance rights has become common market practice when setting up a company for an IPO as a means of allowing favored stockholders to maintain control. Additionally, the Court implied that several of the invalid provisions may have been enforceable if they were included in the company’s certificate of incorporation as opposed to the stockholder agreement. Finally, it is worth noting that this decision does not cover stockholder agreements where the contract sets forth an arrangement between two or more stockholders about how they will exercise voting rights. Moving forward, it will be particularly important for both stockholders and directors to consult corporate counsel and discuss applicable limitations under the DGCL when implementing stockholder agreements and other governance arrangements.

For additional information or assistance regarding best practices for stockholder agreements and corporate governance, contact Matthew M. McDonald at mmmcdonald@klehr.com or Elizabeth Webb Bucilla at ebucilla@klehr.com.

Co-authors Matthew M. McDonald, partner, and Elizabeth Webb Bucilla, associate, are members of the Corporate & Securities Department at Klehr Harrison.