In his opinion West Palm Beach Firefighters’ Pension Fund v. Moelis & Company (the “Opinion”)ⁱ, Delaware Vice Chancellor Travis Laster laid down some of the boundaries of valid and invalid terms of stockholders’ agreements governing Delaware corporations. While the Opinion declares invalid a host of provisions commonly found in such agreements relating to veto and board representation rights, it also provides important guidance as to the alternative pathways available to corporate planners. Specifically, the Opinion directs corporations and stockholders to set forth governance matters in the certificate of incorporation, preferred stock designations or bylaws, in line with the statutory Delaware General Corporation Law (“DGCL”) scheme.

Overview of the Case

In connection with the 2014 IPO of Moelis & Company (the “Company”), its founder and then-majority stockholder, Ken Moelis (“Mr. Moelis”)ⁱⁱ, entered into a stockholders’ agreement with the Company (the “Stockholders’ Agreement”). The Stockholders’ Agreement contained two sets of provisions at issue in the case: (i) an extensive set of pre-approval (i.e. veto) rights for Mr. Moelis, requiring the Company board to obtain Mr. Moelis’s prior written approval before taking any of the specified 18 types of actions; and (ii) a set of provisions designed to guarantee Mr. Moelis’s nominees a majority on the Company board and a proportionate number of seats on each of the board’s committees.

The court invalidated the veto rights in their entirety, deeming them to violate Section 141(a) of the DGCL, under which, unless otherwise specified in the DGCL or the certificate of incorporation, “the business and affairs of every corporation … shall be managed by or under the direction of a board of directors”.

The court took a more granular approach to board and committee composition rights. Mr. Moelis’s rights to identify and nominate board candidates were upheld as facially valid, as was the requirement that the Company take reasonable best efforts to facilitate the election and continued service of Mr. Moelis’s designees. Such provisions, however, might still be subject to challenges if their application results in violation of Section 141(a) of the DGCL or other statutory provision. With regard to the Company’s obligation to take best efforts, in particular, the court cited inclusion of Mr. Moelis’s nominees on the Company’s proxy statement and proxy card as a permissible way of complying with the best efforts obligation.

At the same time, the court invalidated provisions (i) fixing the maximum board size, (ii) requiring the board to recommend Mr. Moelis’s nominees for election and to fill any vacancy created by the death, disability, retirement, resignation or removal of a nominee of Mr. Moelis with another nominee of Mr. Moelis, and (iii) granting Mr. Moelis proportionate representation on the board’s committees. In the court’s view, similarly to the veto rights, such provisions encroached upon the authority of the board contrary to DGCL Section 141(a).

It remains to be seen whether the Opinion will be appealed. Further, as the court acknowledged, the provisions declared invalid are consistent with market practice and a considerable volume of litigation seeking to invalidate similar provisions in other stockholders’ agreements could, therefore, be expected. In turn, such litigation may lead to further clarification or “fine-tuning” of the Opinion’s holdings, or reveal different approaches taken by different members of the Delaware Court of Chancery.ⁱⁱⁱ

Key Takeaways

• Corporate planners should seek to establish governance arrangements by the means expressly contemplated by DGCL. Having invalidated the veto rights and board composition rights in the Stockholders’ Agreement, the court emphasized that Mr. Moelis “could have accomplished the vast majority of what he wanted through the Company’s certificate of incorporation”, given the express option under DGCL Section 141(a) to limit or alter the board-centric governance in the certificate of incorporation. As an alternative expressly endorsed by the court, a corporation can issue even a single share of preferred stock under the blank check preferred stock authority (to the extent contained in the certificate of incorporation) with specific voting and director appointment rights, and a certificate of designation with respect to such preferred stock would become part of the certificate of incorporation upon filing with the Delaware Secretary of State.^iv The maximum number of directors can be set forth in the corporation’s certificate of incorporation or bylaws.^v
  
  Therefore, depending on the circumstances, including the feasibility of obtaining stockholder vote, corporate planners should set forth the necessary governance provisions in the certificate of incorporation or preferred stock certificate of designation.
  
  In corporations with one or more other significant stockholders, “traditional” stockholders’ agreements (that would not be able to limit the board’s power based on the Opinion) may be able to provide additional protection, for example, in ensuring the necessary stockholder support for election of director nominees or a particular manner of voting with respect to matters proposed to stockholders, such as amendments to the certificate of incorporation or mergers. 

• Contractual provisions giving a particular stockholder(s) board representation rights require careful drafting. Under the Opinion, stockholders’ agreements may expressly grant to a stockholder the right to nominate a director for at the annual meeting of stockholders and to have the company include such nominee in the proxy statements and on the proxy card. However, the stockholder cannot be contractually entitled to have its nominee recommended by the board (i.e., included on the director slate of nominees), to have vacancies created between the stockholder meetings filled with its nominees, to dictate committee composition or to impose restrictions on the board size not found in the certificate of incorporation or bylaws.
  
  
• The Opinion is ambiguous whether, and to what extent, veto rights embodied in a stockholders’ agreement in other transactions would be permissible. The court distinguished between “internal governance agreements” and “external commercial contracts”. Only in the former case would restrictions on the board’s authority be subject to challenges under DGCL Section 141(a); in the latter case, contracting out the restrictions would be a presumptively valid exercise of board power. The court acknowledged that the distinction between the two types would involve analysis of at least seven factors, of which “[a]ll are matters of degree [and n]one are essential”.^vi
  
  The court concluded that supply contracts or credit agreements are “commercial contracts”, while stockholders’ agreements similar to the one at issue are “internal governance arrangements”. Merger agreements, which contain both a commercial exchange between seller and buyer and internal governance arrangements relating to their adoption and board recommendation, are a hybrid of the two types.
  
  The Stockholders’ Agreement was entered into in connection with the Company’s IPO and sought to secure the governance rights of the pre-IPO founder. The court left it for another occasion to analyze agreements (often labeled “investor rights agreements”) between a company and an equity investor (i.e. a new stockholder) made in connection with and at the time of an investment. Such agreements are made between a corporation and its stockholder (an “intra-corporate actor”) and relate to the internal affairs of a corporation. At the same time, such agreements are entered into in connection with a specific investment, seek to protect such investment and often have limited duration. Until the court has ruled otherwise on agreements of such type, veto rights therein may be subject to similar challenges.
  
  Furthermore, the court noted that Mr. Moelis’s veto rights required his approval “for virtually any action the directors might want to take”, but refrained from ruling whether an alternative, more limited set of rights, would be permissible. Absent further guidance from the court, any stockholder veto rights found in a stockholders’ agreement may be open to challenge, although the risk of their invalidity may be lower where the veto rights are more limited.
  
  Similarly, the court noted that “any Section 141(a) assessment of provisions in an activist settlement must wait an appropriate case”. Of the eight Section 141(a) cases currently pending before the court, two involve challenges to activist settlement agreements.^vii In a hearing in one of those, Vice Chancellor Laster noted that there is a “colorable challenge” with respect to an activist settlement agreement provision requiring the board to recommend the new directors to stockholders, even when such provision is subject to a fiduciary out.^viii However, the ultimate disposition of the challenges of governance provisions in the activist settlement context remains pending before the court.
  
  Hopefully, future guidance from the court or any appeals may shed more light on the contours of the new paradigm established by the Opinion.
  
  

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ⁱ C.A. No. 2023-0309-JTL, 2024 WL 747180 (Del. Ch. Feb. 23, 2024), available at https://courts.delaware.gov/Opinions/Download.aspx?id=360460.

ⁱⁱ While the immediate party to the Stockholders’ Agreement is Moelis & Company Partner Holdings, LP, a limited partnership controlled by Mr. Moelis, the Opinion functionally equates Mr. Moelis and the partnership for the purposes of its analysis; this client alert follows the Opinion’s approach. 

ⁱⁱⁱ As of March 26, 2024, there were at least eight other cases pending before the Delaware Court of Chancery in which the plaintiffs seek to invalidate stockholders’ or similar agreements’ provisions based on DCGL Section 141(a) (Patrick Quade v. Apollo Global Management, No. 2024-0254-NAC; Bruce Taylor v. L3Harris Technologies, Inc., No. 2024-0205-JTL; Theodore B. Miller, Jr. and Boots Capital Management LLC. v. P. Robert Bartolo, et al., No. 2024-0176-JTL; Chamandeep Kaur v. Scooby Aggregator, LP, et al., No. 2024-0129-KSJM; Vladimir Gusinsky Revocable Trust v. Eric Remer, et al., No. 2024-0077-PAF; Bruce Taylor v. Raul Alvarez, et al., No. 2024-0058-JTL; Bruce Taylor v. Driven Equity LLC, et al., No. 2023-1256-JTL; Eric Maglione v. Joseph Konowiecki, et al., No. 2023-0691-JTL).

^iv DGCL Sections 102(a)(4), 104, 141(d), 151(a) and 151(g). Relying on prior case law, the court noted that some board powers, such as the power to propose amendments to certificate of incorporation and enter into merger agreements (both subject to stockholder approval), as well as certain board composition arrangements, such as naming directors in the certificate of incorporation or providing for their permanent tenure, would still be impermissible as violative of DGCL mandatory rules.

^v DGCL Section 141(b).

^vi Under the Opinion’s analysis, governance arrangements, as opposed to commercial contracts, (i) are often based on a particular DGCL provision; (ii) are made between “intra-corporate actors” (directors, officers and/or stockholders); (iii) establish the terms on which such “intra-corporate actors” can authorize the exercise of a corporation’s corporate powers; (iv) do not involve “an underlying commercial exchange”; (v) have corporate governance as an object in itself, rather than as a means to protect an underlying transaction; (vi) normally, cannot be enforced by damages for breach and do not leave room for corporate actors “to act freely subject to a contractual consequence”; and (vii) are typically long-term or indefinite and cannot be terminated by the company.

^vii Bruce Taylor v. L3Harris Technologies, Inc., No. 2024-0205-JTL; Theodore B. Miller, Jr. and Boots Capital Management LLC. v. P. Robert Bartolo, et al., No. 2024-0176-JTL.

^viii Theodore B. Miller, Jr. and Boots Capital Management LLC. v. P. Robert Bartolo, et al., No. 2024-0176-JTL, Hearing on Motion to Expedite and for a TRO Held Via Zoom, March 8, 2024, at p. 67, available at: https://static1.squarespace.com/static/65aeb3e2789e5f0788193e6a/t/65f329e64f882d6e40c4fe04/1710434790959/3-8-24MillervBartolo-2024-0176-JTL-915amZoom.pdf.

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