NEW ENTERPRISE ASSOCIATES 14, L.P., NEA VENTURES 2014, L.P., NEA:SEED II, LLC, and CORE CAPITAL PARTNERS III, L.P., Plaintiffs, v. GEORGE S. RICH, SR., DAVID RUTCHIK, JOSH STELLA, FUGUE, INC., GRI VENTURES, LLC, JMI FUGUE, LLC, RICH FAMILY VENTURES, LLC, and RUTCHIK DESCENDANTS’ TRUST, Defendants.
C.A. No. 2022-0406-JTL
IN THE COURT OF CHANCERY OF THE STATE OF DELAWARE
Date Submitted: January 24, 2023; Date Decided: May 2, 2023
OPINION DENYING MOTION TO DISMISS BASED ON COVENANT NOT TO SUE FOR BREACH OF FIDUCIARY DUTY
John P. DiTomo, Sebastian Van Oudenallen, MORRIS, NICHOLS, ARSHT & TUNNELL LLP, Wilmington Delaware; Patrick Montgomery, Paul Weeks, KING & SPALDING LLP, Washington, District of Columbia; Attorneys for Defendants.
LASTER, V.C.
This decision grapples with a conflict between two elemental forces of Delaware corporate law: private ordering and fiduciary accountability. Ordinarily, those forces operate harmoniously. Here, they pull in opposite directions.
Viewed from the standpoint of private ordering, this might seem like an easy case for contract enforcement: Sophisticated stockholders granted another investor a contract right to engage in a transaction that met specified criteria, and they promised not to sue the investor or its affiliates and associates if the investor exercised that right. The investor committed capital to the corporation in reliance on the stockholders’ promise. Later, the investor exercised its contract right. Now, the stockholders are doing what they said they wouldn‘t do: sue over the transaction.
But like an Escher lithograph, the image changes with the viewer‘s perspective. The claims that the stockholders promised not to assert include claims for breach of fiduciary duty. The investor became the corporation‘s controlling stockholder, and individuals affiliated or associated with the investor took over the board of directors. The stockholders contend that by engaging in the contractually authorized transaction, the investor and the directors breached their duty of loyalty. In contrast to Delaware‘s alternative entity statutes, the Delaware General Corporation Law (the “DGCL“) permits only limited fiduciary tailoring. Viewed from the standpoint of fiduciary accountability, this might seem like an easy case for contractual invalidity.
With the stage set, let‘s dig in. The plaintiffs are investment funds (the
The Funds did not want to increase their financial commitment. Management represented that the only option was a recapitalization led by George Rich (the “Recapitalization“). He would only commit if (i) all existing preferred stock became common stock, (ii) Rich and his fellow investors received a new class of preferred stock (the “Preferred Stock“), and (iii) the Funds and other significant investors executed a voting agreement (the “Voting Agreement” or “VA“). The Funds accepted Rich‘s terms. They were given the chance to participate in the Recapitalization, but they declined.
The Voting Agreement contains a drag-along right. It provides that if the Company‘s board of directors (the “Board“) and the holders of a majority of the Preferred Stock approve a transaction that meets a list of eight criteria, then the signatories must participate (the “Drag-Along Sale“). Critically for this case, the signatories covenanted not to sue Rich or his affiliates or associates over a Drag-Along Sale, including by asserting claims for breach of fiduciary duty (the “Covenant“).
An opportunity to sell the Company soon materialized. The Company and the acquiror negotiated a Drag-Along Sale. That transaction has now closed.
In Counts VI, VII, and VIII of their complaint (the “Sale Counts“), the Funds have challenged the Drag-Along Sale and asserted claims for breach of fiduciary duty. The defendants argue that in light of the Covenant, the Sale Counts must be dismissed.
The Funds acknowledge that the Covenant covers their claims, and they concede that it was an inducement for Rich to invest. They assert that the Covenant is facially invalid.
The argument for facial invalidity starts from the settled proposition that fiduciary relationships are creatures of equity. The key move comes next and asserts that equity does not countenance limitations on fiduciary duties except to the extent authorized by statute. The DGCL does not authorize a provision like the Covenant. Therefore, the argument goes, it is contrary to Delaware public policy and cannot be enforced.
The argument against facial invalidity takes longer to unspool. It starts by recognizing that fiduciary duties can be tailored, even without statutory authorization. At the heart of every fiduciary relationship is an obligation of loyalty that cannot be eliminated without destroying its fiduciary character. Parties can, however, orient the obligation by specifying a purpose for the relationship, and they can authorize the fiduciary to take specific actions that otherwise would constitute a breach. Two paradigmatic fiduciary relationships—that of trustee to beneficiary and agent to principal—exemplify those opportunities for tailoring.
The argument next shows that Delaware corporate law adheres to those longstanding principles. The DGCL permits corporate planners to orient the fiduciary relationship between the directors and the corporation and its stockholders through a purpose clause. The directors must pursue the corporate purpose selflessly for the benefit of the corporation and its stockholders, but they are limited to pursuing the corporation‘s purpose. They cannot
Having shown that corporate fiduciary duties are not immutable, the argument against facial invalidity turns to the contractarian nature of Delaware corporate law. A close analysis of the DGCL shows that through a private agreement, stockholders can agree to more constraints on their ability to exercise stockholder-level rights than corporate planners can impose through the charter or bylaws. The Covenant appears in a stockholder-level agreement and concerns a stockholder-level right.
This in-depth analysis indicates that the Covenant is not out of bounds as a form of fiduciary tailoring. The analysis next turns to other indications of where Delaware might draw a public policy line.
An intuitively appealing argument asserts that a claim for breach of the duty of loyalty is too big to waive. One way to evaluate that argument is to consider what else is waivable. Delaware law permits individuals to waive significant liberty and property interests that are arguably weightier than a right appurtenant to a share. The comparison suggests that the Covenant is not facially invalid.
A rhetorically powerful argument asserts that permitting stockholders to covenant not to sue for breach of the duty of loyalty would conflict with Delaware‘s corporate brand, which promises standardized terms, including an immutable duty of loyalty. The promise of standardized terms should not be overstated, because Delaware‘s support for private ordering means that an investor cannot assume that one Delaware corporation is like another. The promise of an immutable duty of loyalty is also overstated, because the duty can be oriented and tailored. Regardless, a stockholder-level agreement about the exercise of stockholder-level rights does not undermine the corporate brand, because the underlying rights remain intact. Each stockholder receives the underlying rights and can exercise them. The stockholder-level agreement only binds its signatories and only affects how they exercise their rights.
Another rhetorically powerful argument asserts that permitting a stockholder to covenant not to sue for breach of the duty of loyalty will collapse the distinction between a corporation and an LLC. That is not so, as the fundamental differences between corporations and LLCs operate at the basal level of their statutes and constitutive documents. There is a superficial similarity between the ability of investors in corporations and LLCs to contract about their investor-level rights, but that resemblance does not turn corporations into LLCs.
A final argument for invalidity relies on the Delaware Supreme Court‘s decision in Manti Holdings, LLC v. Authentix Acquisition Co.1 There, sophisticated stockholders agreed to a drag-along provision in which they covenanted not to pursue their appraisal rights. The stockholders sought to escape their promise by arguing that the provision conflicted with the DGCL and was contrary to Delaware public policy.
A majority of the Delaware Supreme Court upheld the appraisal waiver, stressing the contractual freedom that Delaware corporate law provides and citing a list of factors that apply equally to this case. But
The majority and dissenting opinions in Manti raise questions about whether a provision like the Covenant goes too far. This decision‘s review of trust law, agency law, the DGCL, and Delaware common law reveals that each authorizes provisions that allow fiduciaries to engage in specific transactions that otherwise would constitute a breach. The Covenant is sufficiently specific because it only applies to a transaction that meets the eight criteria required for a Drag-Along Sale. The Funds did not broadly covenant not to assert any claims for breach of fiduciary duty. They agreed not to sue over a specific transaction with specific characteristics.
The Covenant is therefore not facially invalid. It is also not invalid on the facts of the case. In Manti, the Delaware Supreme Court considers a series of factors, including (i) the presence of a written contract, (ii) the clarity of the waiver, (iii) the stockholder‘s understanding of the waiver‘s implications, (iv) the stockholder‘s ability to reject the provision, (v) the existence of bargained-for consideration, and (vi) the stockholder‘s sophistication. The proponent of the provision must establish that enforcement is reasonable.
This case provides an optimal scenario for enforcement. The Covenant appears in the Voting Agreement. It is a clear and specific. The Funds are sophisticated repeat players who understood its implications. It tracks a provision that appears in a model agreement sponsored by the National Venture Capital Association (the “NVCA“), and one of the venture capital firms behind the Funds is a member of the NVCA. The Covenant was part of a bargained-for exchange that induced Rich to lead the Recapitalization, his fellow investors to participate, and Rich and his colleague to serve on the Board. The Funds were the dominant incumbents in the cap table. If they did not like the Recapitalization, they could have blocked it, forced the Company to seek different terms, or funded the Company themselves. If they saw no alternative but thought Rich had secured a great deal, then they could have joined the investor group. They decided to pass, agreed to the Covenant, and let Rich and his investor group take the risk.
This decision cannot conclude that the Covenant is invalid as applied to these facts. That does not mean that the Delaware courts will enforce similar provisions. A covenant not to sue resembles another powerful provision: the covenant not to compete. Like a covenant not to sue, sophisticated parties can use a covenant not to compete to create value, but covenants not to compete can be abused, and this court examines them closely.
Parties should expect a similar hard look for covenants not to sue. A broad waiver of any ability to assert claims for breach of fiduciary duty would be a non-starter. Even a narrowly tailored provision would likely be unreasonable if it appeared in an agreement that purported to restrict the rights of retail stockholders.
Although the Covenant is not wholly invalid, either facially or as applied, its scope still stretches beyond what Delaware law allows. Delaware law generally prohibits contractual provisions that purport to exculpate a party for tort liability resulting from intentional or reckless harm. Delaware corporate law is more permissive and treats recklessness as a form of gross negligence, thereby expanding the power to exculpate to encompass recklessness. There is only one situation where Delaware
The Covenant purports to bar all challenges to the Drag-Along Sale. It cannot insulate the defendants from tort liability based on intentional wrongdoing, but it can protect against other claims. The Sale Counts rely on facts supporting an inference that the defendants could have acted intentionally and in bad faith to benefit themselves and harm the common stockholders during the lead up to the Drag-Along Sale. The Sale Counts therefore cannot be dismissed at the pleading stage. The defendants’ motion to dismiss based on the Covenant is denied.
I. FACTUAL BACKGROUND
The facts are drawn from the operative complaint and the documents that it incorporates by reference.3 The defendants argued that the complaint failed to state a claim on which relief could be granted for reasons other than the Covenant, and the court issued an opinion addressing those contentions (the “Pleading Decision“).4 The Sale Counts survived dismissal, necessitating consideration of the Covenant. This decision incorporates the factual background from the Pleading Decision and only summarizes the information pertinent to the Covenant.
A. The Company
Founded in 2012, the Company provides tools to build, deploy, and maintain a cloud infrastructure security platform. Josh Stella served as its Chief Executive Officer.
In 2013, plaintiff Core Capital Partners III, L.P. (“Core Capital“) led the Company‘s seed round. Core Capital is an investment fund sponsored by Core Capital Partners, a venture capital firm based in Washington, D.C.
In 2014, plaintiffs New Enterprise Associates 14, L.P., NEA Ventures 2014, L.P., and NEA: Seed II, LLC, invested in the Company. Each is an investment fund sponsored
by New Enterprise Associates, a name-brand venture capital firm. The term “Funds” refers to the entities sponsored by NEA and Core Capital that invested in the Company.
Over multiple financing rounds, the Funds invested almost $39 million in the Company. In return, they received shares of preferred stock that carried special rights. Each of the Funds also received the right to appoint one member of the Board.
B. The Failed Sale Process And The Recapitalization
By 2020, Core Capital had been invested in the Company for seven years, and NEA
The Funds urged Stella to seek a liquidity event. Starting in the second half of 2020, the Company sought a buyer.
Toward the end of the first quarter of 2021, Stella told the Board that the effort had failed. Stella represented that the Company needed capital, and he recommended that the Company engage in the Recapitalization. The Board authorized him to proceed.
C. The Terms Of The Recapitalization
In the Recapitalization, the Company raised roughly $8 million by issuing shares of Series A-1 Preferred Stock (the “Preferred Stock“) to Rich and his investor group. Rich invested through two vehicles, one of which was designated as the “Lead Investor” under the transaction agreements. Rich controlled the investment vehicles through a third entity. All three entities are defendants (together, the “Rich Entities“).
Twenty-three other investors participated in the Recapitalization. Eleven already owned common stock in the Company. Another five were Company employees. Only seven appear to be new investors. The Funds declined to participate.
The terms of the Recapitalization were onerous for the incumbent stockholders. Rich insisted that all of the preferred stock convert into common stock and that key stockholders execute the Voting Agreement. All of the investors in the Recapitalization executed the Voting Agreement, as did twenty-nine of the existing stockholders (the “Signatories“). The Funds were Signatories.
In the Voting Agreement, the Signatories agreed to vote for (i) one director designated by the Lead Investor, (ii) a second director designated by the holders of a majority of the Preferred Stock, (iii) a third director elected by a majority of the Preferred Stock held by investors other than the Lead Investor, (iv) the CEO, and (v) one director designated by all the outstanding stock voting together as a single class. After the Recapitalization, the Board‘s five members were Stella, two independent directors who carried over from before the Recapitalization, and two representatives of the new investors. Rich joined the Board as the designee of the Lead Investor. David Rutchik joined as the director designated by the holders of a majority of the Preferred Stock. Rutchik had participated in the Recapitalization through his affiliate, the Rutchik Descendants’ Trust (the “Rutchik Trust“).
Importantly for this decision, Section 3.2 of the Voting Agreement contains the Drag-Along Right. That provision obligates the Signatories to support a Drag-Along Sale and includes the Covenant.
D. An Expression Of Interest And The Interested Transactions
In late June 2021, a potential acquirer contacted Stella. The outreach contrasted with the Company‘s failed sale process. The contact was preliminary, but it put a different cast on the Company‘s situation.
On July 14, 2021, the two independent directors resigned, leaving Stella, Rich, and Rutchik as the only members of the Board. One week later, they authorized the Company to issue another 3,938,941 shares of Preferred Stock. The buyers were nine entities and individuals, including the Rich and Rutchik. Rather than treating the issuance as a new transaction, the Board amended the terms of the Recapitalization and pretended that the second issuance was part of the original deal. That move enabled the buyers to acquire the shares at the same price and on the same terms that Rich had
Later that same month, on July 29, 2021, the Board approved grants of stock options. Many of the recipients were Company employees, but large grants went to the three directors.
The Funds contend that the second issuance of Preferred Stock and the grants of options to the insiders (together, the “Interested Transactions“) constituted breaches of fiduciary duty. They allege that the Interested Transactions were obvious instances of self-dealing on terms that appear facially unfair to the Company and highly beneficial to Rich and his confederates.
E. The Merger
While those events were transpiring, discussions with the acquirer moved forward. By September 2021, they were negotiating a merger agreement. In December, the Board told the stockholders about an agreement in principle to sell the Company for $120 million in cash.
On February 12, 2022, the Company sent the Funds a draft merger agreement with a joinder agreement and voting form. The Company told the Funds that they were obligated to sign the joinder agreement and voting form.
Section 1.1 of the joinder agreement bound each signatory to vote in favor of the merger and against any competing proposal. In Section 1.2 of the joinder agreement, each signatory released any and all claims against the Company, the directors, and their associates and affiliates.
The Funds agreed to sign the documents if Stella and Rich attested that they had not had any communications with the acquirer about a potential transaction before the Recapitalization. Their counsel promised to provide the affirmations.
On February 17, 2022, the Company announced that it had executed the merger agreement and closed the transaction. On February 18, 2022, Stella and Rich‘s counsel proposed substantially narrower affirmations. The Funds refused to sign the joinder agreement and voting form. On February 21, the Company circulated a distribution waterfall that revealed the Interested Transactions.
F. This Litigation
On May 9, 2022, the Funds filed this lawsuit. The complaint contained eight counts, three of which comprise the Sale Counts. Count VI contends that Rich, Rutchik, and Stella breached their fiduciary duties as directors by approving the Drag-Along Sale. Count VII contends that the Rich Entities breached their fiduciary duties as controlling stockholders by approving the Drag-Along Sale. Count VIII alleges that the Rutchik Trust aided and abetted the fiduciaries’ breaches of duty. The gist of those claims is that the Drag-Along Sale (i) failed to provide any consideration for derivative claims relating to the Interested Transactions and (ii) conferred a unique benefit on Rich, Rutchik, Stella, and their affiliates by extinguishing the standing of sell-side stockholders to pursue those claims. The Funds contend that the Drag-Along Sale was therefore an interested transaction subject to the entire fairness test and that the defendants cannot establish that it was entirely fair.
The defendants moved to dismiss the complaint. In the Pleading Decision, the court held that the Sale Counts stated claims on which relief. The Pleading Decision did not reach the defendants’ argument that the Covenant foreclosed the Sale Counts.
The defendants contend that the Covenant bars the Funds from asserting the Sale Counts. The defendants invoked the Covenant through a motion to dismiss under Rule 12(b)(6). When considering a Rule 12(b)(6) motion, the court (i) accepts as true all well-pled factual allegations in the complaint, (ii) credits vague allegations if they give the opposing party notice of the claim, and (iii) draws all reasonable inferences in favor of the plaintiffs. Dismissal is inappropriate “unless the plaintiff would not be entitled to recover under any reasonably conceivable set of circumstances.”5
The existence of a contractual bar to suit, such as a release or a covenant not to sue, is an affirmative defense that must be asserted in a responsive pleading.6 A court can consider a contractual bar to suit under Rule 12(b)(6) if the complaint incorporates the document by reference or if the document is subject to judicial notice.7 In this case, the court can consider the Covenant because it is part of the Voting Agreement, which the complaint incorporates by reference.
A. The Nature Of A Covenant Not To Sue
A covenant not to sue is a contract in which a potential claimant commits not to assert specified claims against a potential defendant. A covenant not to sue and a release are different things. “A covenant not to sue or execute is distinguished from a release as a
forbearance of a right rather than a discharge of liability.”8 Historically, that distinction carried significance,
When determining the scope of a covenant not to sue, a court construes its terms like any other contract.11 When multiple claims or multiple defendants are involved, the covenant not to sue only applies to the claims and defendants that fall within its scope.12 A covenant not to sue can apply “to future as well as to present claims.”13 Unlike a release, where the cancellation of the claim and the discharge of the released party are complete upon execution, the covenant not to sue is an executory contract that contemplates ongoing performance.14
Covenants not to sue are generally valid, “as public policy is in no way concerned with the option which a person has to sue or to forbear suit.”15 Some jurisdictions impose public policy limitations on covenants not to sue.16 Illinois common law prevents covenants not to sue from “exculpating persons from the consequences of their willful and wanton acts.”17 New York common law prohibits contracts that prospectively limit a party from
liability for willful or grossly negligent acts.18 Delaware applies the same public policy limitations to covenants not to sue that it applies to contracts generally. Extant decisions hold that a provision in a commercial contract cannot eliminate tort liability for intentional or reckless conduct.19
B. The Scope Of The Covenant
The Covenant in this case is part of the Drag-Along Right. It is not part of a settlement of all claims arising out of or relating to a particular transaction or event. If it were, there would be no question about its validity, because parties can release claims for breach of fiduciary duty
The Covenant creates issues because it is forward-looking. It applies when the Drag-Along Right is properly exercised. For that to happen, the transaction must qualify as a “Sale of the Company,” defined as either (i) a stockholder-level sale 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.21
For the Drag-Along Right to apply, the Sale of the Company must receive approval from both (i) the holders of a majority of the issued and outstanding shares of Preferred Stock, and (ii) the Board, including the director appointed by the Lead Investor and at least one other director approved by the holders of the Preferred Stock.22 If the Drag-Along Right applies, then the Signatories must fulfill a series of contractual commitments. But no Signatory has to comply with those obligations unless the Sale of the Company satisfies eight requirements. This decision defines a Sale of the Company that meets the eight requirements as a Drag-Along Sale. In abbreviated form, the requirements include:
- Each holder of shares of stock of each class or series must receive the same form and amount of consideration as the other shares in their class or series,23
- The transaction consideration must be distributed in order of priority as set forth in the charter,24
- If there is a choice of consideration, then each holder receives the same choices,25
- Signatories cannot be required to make representations and warranties except as to the ownership of, authority over, and ability to covey title to their shares,26
- Signatories cannot be required to agree to restrictive covenants,27
- Signatories cannot be required to terminate or alter any contractual agreements with the Company,28
- Signatories cannot have any liability for a breach of any representation,
warrant, or covenant, except to the extent paid from an escrowed portion of the transaction consideration designated for that purpose,29 and - Signatories cannot be required to fund the escrow beyond their pro rata share of the negotiated amount.30
Because of these conditions, the Drag-Along Right does not apply to a transaction in which the Rich Entities extract additional or unique consideration for themselves.
If the Drag-Along Right applies, then each Signatory must take a series of actions. They include:
- Voting for the Drag-Along Sale if it requires stockholder approval,31
- Executing and delivering documentation in support of the Sale of the Company that the Company reasonably requests,32
- Agreeing to appoint a stockholder representative with authority to take action under the transaction documents after closing,33 and
- Agreeing to the Covenant.34
Under the Covenant, each Signatory commits
to refrain from (i) exercising any dissenters’ rights or rights of appraisal under applicable law at any time with respect to such Sale of the Company, or (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 (including, without limitation, aiding and abetting breach of fiduciary duty) in connection with the evaluation, negotiation or entry into the Sale of the Company, or the consummation of the transactions contemplated thereby.35
Each Signatory thus covenants both to waive appraisal rights and not to assert any challenge to the Sale of the Company or any claim for breach of fiduciary duty or aiding and abetting against “the Electing Holders or any affiliate or associate thereof.”
The parties agree that the Drag-Along Sale met the contractual requirements and triggered the Signatories’ obligations. The parties agree that the Covenant encompasses all of the defendants. They agree that it covers the Sale Counts.36
Particularly for NEA, that would be a difficult argument to make, because NEA is a member of the NVCA, and the Covenant tracks a provision in the model voting agreement sponsored by that organization.37 Under that provision, a signatory agrees
to refrain from (i) exercising any dissenters’ rights or rights of appraisal under applicable law at any time with respect to such Sale of the Company, or [(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 Selling Investors or any affiliate or associate thereof (including, without limitation, aiding and abetting breach of fiduciary duty) in connection with the evaluation, negotiation or entry into the Sale of the Company, or] the consummation of the transactions contemplated thereby].38
The Covenant adopts the most expansive formulation of the model provision by including the bracketed language.
A comment in the model provision explains the intent of the bracketed language:
[C]ommon and subordinate preferred stockholders are increasingly filing breach of fiduciary duty claims seeking quasi-appraisal — i.e., damages that mirror the recovery available in an appraisal suit — in transactions subject to drag-along provisions where the junior preferred or common shareholders are to receive no consideration for their shares. Because the directors are often representatives of the senior preferred holders, these suits are difficult to dismiss at an early stage. Accordingly, consideration should be given to expanding the agreement . . . to cover breach of fiduciary suits in transactions subject to the drag along.39
The commentary confirms that the Covenant is intended to do what it says and bar breach of fiduciary duty claims based on the Drag-Along Sale.
The defendants’ motion squarely presents the question of the Covenant‘s validity. This is not a case where ambiguity exists about whether a waiver extends to breach of fiduciary duty claims.
C. The Case For Facial Invalidity
The Funds’ case for holding the Covenant facially invalid is short and sweet: “Under well-settled law, parties cannot waive fiduciary duties of loyalty in Delaware corporations.”40 In support of that proposition, the Funds cite Section 102(b)(7) of the DGCL, which limits the extent to which a charter provision can
relatively few authorities for an absolutist proposition. The Funds seem to treat it as self-evident that a provision like the Covenant is facially invalid.
The Funds would have done better to rely on Totta v. CCSB Financial Corp.,42 where Chancellor McCormick addressed the ability of corporate planners to displace equity‘s power to impose fiduciary duties, evaluate compliance through standards of review, and impose equitable remedies. Totta involved a provision in the certificate of incorporation of a bank holding company that prohibited any stockholder from exercising more than 10% of the company‘s voting power in an election. To minimize disputes over the application of the provision, the charter provided that “[a]ny constructions, applications, or determinations made by the Board of Directors pursuant to this section in
good faith and on the basis of such information and assistance as was then reasonably available for such purpose shall be conclusive and binding upon the Corporation and its stockholders” (the “Conclusive-And-Binding Provision“).43 Facing a proxy contest, the incumbent directors interpreted the voting power limitation to apply not only to ownership by a single stockholder, but also to stockholders acting in concert. The new interpretation resulted in the defeat of the insurgent slate.
Fiduciary duties arise in equity and are a fundamental aspect of Delaware law. The constitutive agreements that govern an entity can only eliminate or modify fiduciary duties and the attendant judicial standards of review to the extent expressly permitted by an affirmative act of the Delaware General Assembly. The General Assembly has granted broad authorization to modify or eliminate fiduciary duties and attendant standards of review in some types
of entities. The General Assembly has granted only limited authority to corporations.45
The Chancellor cited Sections 102(b)(7) and 122(17) of the DGCL as the sole provisions through which the General Assembly has authorized limitations on equitable review and fiduciary accountability.46 She noted that the General Assembly had never expressly authorized a charter provision that could modify the standard of review. As a result, the Chancellor concluded that the Conclusive-And-Binding Provision was invalid.
Chancellor McCormick grounded the persistent power of equity on the constitutional grant of equity jurisdiction to this court: “The Constitution of 1897 retains the distinction between law and equity, and the General Assembly has empowered [the Court of Chancery] to hear and determine all matters and causes in equity.”47 After citing
the Delaware Supreme Court‘s decision in DuPont v. DuPont,48 she made the following observation:
In the hierarchy of law-making in a democratic regime, courts defer to legislatures. Within constitutional limits, the General Assembly can replace equity with statutory law. For purposes of entity law, that means the General Assembly has the authority to eliminate or
modify fiduciary duties and the standards that are applied by this court, or to authorize their elimination or modification through private ordering.49
Thus, if the General Assembly has authorized provisions in the constitutive documents of an entity that eliminate or modify the fiduciary duty regime, then a court will enforce them. Otherwise, practitioners cannot use the constitutive documents of an entity for that purpose.50
In Delman v. GigAcquisitions3, LLC,51 Vice Chancellor Will relied on Totta to hold that stockholders were not estopped from asserting a claim for breach of the duty of loyalty simply because the potential conflicts of interest faced by the corporate fiduciaries “were disclosed in the prospectus when the plaintiff invested . . . and again in the Proxy” issued in connection with the transaction they challenged.52 She posited that “[s]uch an approach
Delaware Supreme Court explained that through this grant of authority, the framers of the Constitution of 1897
intended to establish for the benefit of the people of the state a tribunal to administer the remedies and principles of equity. They secured them for the relief of the people. This conclusion is in complete harmony with the underlying theory of written constitutions. Its result is to establish by the Judiciary Article of the Constitution the irreducible minimum of the judiciary. It secures for the protection of the people an adequate judicial system and removes it from the vagaries of legislative whim.
Id. One scholar has argued that DuPont creates “substantial doubt” about whether fiduciary duties can be waived or eliminated at all, even with statutory authorization from the General Assembly. Lyman Johnson, Delaware‘s Non-Waivable Duties, 91 B.U. L. Rev. 701, 702 (2011). I would not go that far, because the weight of authority demonstrates that fiduciary duties can be tailored. There is arguably an open question as to whether the General Assembly can constitutionally authorize provisions that purport to eliminate all fiduciary duties or capaciously limit them without ensuring the existence of an adequate remedy at law. Experience has shown that contractual remedies and the implied covenant of good faith and fair dealing are not fiduciary substitutes. See generally Leo E. Strine, Jr. & J. Travis Laster, The Siren Song of Unlimited Contractual Freedom, in Research Handbook on Partnerships, LLCs and Alternative Forms of Business Organizations (Robert W. Hillman & Mark J. Loewenstein eds., 2014). Although it hardly seems likely that the Delaware courts would rely on DuPont to pare back the blanket authorization for waiving or limiting fiduciary duties that appear in the alternative entities statutes, the DuPont decision provides insight into equity‘s true potential.
would be inconsistent with the fundamental principles of our law” and stated that that “Delaware corporate law ‘does not allow for a
The Funds argue that the Covenant disguises the wolf of an impermissible limitation on fiduciary duties in the sheep‘s clothing of a stockholder-level agreement. That, they say, is no distinction at all. Under their bright-line approach, the Covenant is facially invalid.
The Funds have advanced one reasonable interpretation of the law, but it is a stark account that elevates fiduciary accountability above all else, fails to explore the permissible bounds of fiduciary tailoring, and ignores the difference between limitations in the constitutive documents of an entity and limitations in a stockholder-level agreement. The Funds’ absolutist framing pays no heed to the importance of private ordering, which is another fundament of Delaware entity law.
I have no quarrel with Totta because that case dealt with a charter provision. The creation of a body corporate through the issuance of a charter constitutes an exercise of state authority, equivalent in its efficacy to the enactment of a statute (notwithstanding the now longstanding practice of the state approving charters under a general incorporation law). Through the issuance of a charter, the state creates an otherwise impossible being—an artificial person—capable of exercising the powers conferred by the state and with the limitations that the state wishes to impose. To use the charter to modify the duties attendant to that state-created relationship, parties should need express authority from the state. I also have no quarrel with GigAcquisitions3, where the defendants sought to achieve fiduciary tailoring through disclosure plus a notion akin to assumption of risk. The reasoning of those cases does not apply to the current dispute, where the Funds voluntarily restricted their ability to exercise stockholder-level rights in a negotiated agreement. The Funds’ position may well be correct, but their authorities do not go that far.
D. The Case Against Facial Invalidity
The argument against the Covenant‘s facial invalidity takes time to unspool. It starts by showing that fiduciary obligations can be tailored. At the heart of a fiduciary relationship lies a nucleus of other-regarding loyalty that cannot be altered or eliminated without rendering the relationship non-fiduciary. But the orientation and scope of the relationship can be modified. Rather than disavowing that framework, Delaware corporate law deploys it, and both the DGCL and the common law permit a greater space for fiduciary tailoring than is commonly recognized. Set within that broader landscape, the Covenant achieves an outcome that tracks what Delaware law already permits. The analysis next
incorporates Delaware‘s support for private ordering, and the Delaware Supreme Court‘s embrace of the contractarian theory of corporate law in Salzberg v. Sciabacucchi56 and Manti. The analysis also takes into account the ability of stockholders to agree to greater restrictions on their stockholder-level rights in a negotiated agreement than what corporate planners can impose through the constitutive documents. With a deeper understanding of what Delaware corporate law permits, the case against the facial invalidity of the Covenant is strong.57
1. Contractual Tailoring Of Fiduciary Duties
“Contractual and fiduciary relationships are the two dominant legal forms of interaction through which persons can pursue individual and shared interests.”58 The two domains, while separate, are deeply intertwined, because many fiduciary relationships are formed through contract.59
The extent to which fiduciary roles can be tailored implicates two competing policies:
First, in a legal order founded on liberal values, individuals should in general be free to set the normative terms on which they interact. This points in favour [sic] of permitting opt outs, so long as relevant legal and other requirements are satisfied. On the other hand, the mediating function of social roles depends on stability in the normative constitution of these roles; where this is lost, roles may lose their traction as normative resources
and people may stop organizing their affairs with reference to them. Where fiduciary law too readily permits opt outs, there is a risk that fiduciary roles might cease to be comprehensible to those whose actions engage with them, and this might generate costs. . . . There are reasons to think that social roles can contribute to human autonomy by providing socially recognized options
agreement before it is sent to a stockholder vote.“). To the extent some have viewed Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914, 933 (Del. 2003), as supporting a similar fiduciary trump card, I have argued otherwise. See J. Travis Laster, Omnicare‘s Silver Lining, 38 J. Corp. L. 795, 818-27 (2013). This case is not about fiduciaries limiting their freedom of action by contract; it is about non-fiduciary stockholders agreeing to a transaction-specific limitation on their ability to assert stockholder-level claims against fiduciaries.
that may be the subject of autonomous choice; thus, there are reasons to be sceptical [sic] about opt outs from a liberal point of view.60
Those twin concerns manifest themselves in Delaware law through the dual principles of private ordering and fiduciary accountability. For different types of fiduciaries, the law may balance the policies differently.61
“[T]he word ‘fiduciary’ is anglicized Latin, meaning trustee-like.”62 Fiduciary duties are thus obligations that are similar to those of a trustee, and a fiduciary relationship is one that is analogous to that between an express trustee and beneficiary.63 Delaware trust law currently authorizes a trust agreement to modify nearly every aspect of a trustee‘s duties.64 By statute, a trust instrument governed by Delaware law may restrict, eliminate, or otherwise vary “[a] fiduciary‘s powers, duties, standard of care, rights of indemnification and liability to persons whose interests arise from that instrument,” subject only to a floor that prevents “exculpation or indemnification of a fiduciary for the fiduciary‘s own wilful [sic] misconduct” or “a court of competent jurisdiction from removing a fiduciary on
account of the fiduciary‘s wilful [sic] misconduct.”65 For purposes of that statutory floor “[t]he term ‘wilful [sic] misconduct’ shall mean intentional wrongdoing, not mere negligence, gross negligence or recklessness and ‘wrongdoing’ means malicious conduct or conduct designed to defraud or seek an unconscionable advantage.”66 Somewhat strangely, Delaware corporate law now stands as the bastion of traditional duties, even
though director duties were less onerous
Let‘s assume, however, that the contractarianism only conquered trust law by statute, such that that director duties remain modeled on those that a trustee owed at common law. Even then, a trust instrument could provide for fiduciary tailoring. A trust instrument could not eliminate the trustee‘s core fiduciary obligation to exercise its powers
in pursuit of what the trustee believed was in the best interests of the beneficiary.69 A trust instrument could specify the beneficiaries of the trust, thereby identifying for whose benefit the trustee had to selflessly pursue the trust‘s purpose.70 A trust instrument could orient the trustee‘s fiduciary duties through a purpose clause or by cabin the trustee‘s discretion by giving specific instructions to the trustee.71 Most importantly for present
Those accommodations for fiduciary tailoring suggest that if the Covenant appeared in a trust instrument, then it would not be facially invalid. The Covenant is part of the Drag-Along Right, which authorizes a contractually specified transaction. That transaction might otherwise constitute a loyalty breach, but a common law trust instrument could authorize such a transaction explicitly. The Covenant becomes a belt-and-suspenders provision that adds an obligation not to sue where a court applying trust law would find no claim.
Another prototypical fiduciary relationship exists between agent and principal. As with trust law, an agency agreement cannot eliminate the core fiduciary obligation that the agent exercise its authority to fulfill its charge from the principal by acting selflessly to pursue what the agent believes to be the principal‘s best interest.73 An agency agreement can orient the agent‘s duties through a narrow purpose clause or cabin the agent‘s discretion
with specific instructions.74 Most significantly for present purposes, agency law permits a principal to consent in advance to specific conduct that otherwise would constitute loyalty breach. Under the blackletter rule,
Conduct by an agent that would otherwise constitute a breach of duty . . . does not constitute a breach of duty if the principal consents to the conduct, provided that
(a) in obtaining the principal‘s consent, the agent
- acts in good faith,
- discloses all material facts that the agent knows, has reason to know, or should know would reasonably affect the principal‘s judgment unless the principal has manifested that such facts are already known by the principal or that the principal does not wish to know them, and
- otherwise deals fairly with the principal; and
(b) the principal‘s consent concerns either a specific act or transaction, or acts or transactions of a specified type that could reasonably be expected to occur in the ordinary course of the agency relationship.75
The commentary explains that these conditions impose “mandatory limits on the circumstances under which an agent may be empowered to take disloyal action.”76
The agency standard draws an important distinction between general attempts at fiduciary waivers and narrowly tailored authorizations.
[A]n agreement that contains general or broad language purporting to release an agent in advance from the agent‘s general fiduciary obligation to the principal is not likely to be enforceable. This is because a broadly sweeping release of an agent‘s fiduciary duty may not reflect an adequately informed judgment on the part of the principal; if effective, the release would expose the principal to the risk that the agent will exploit the agent‘s position in ways not foreseeable by the principal at the time the principal agreed to the release.77
“In contrast, when a principal consents to specific transactions or to specified types of conduct by the agent, the principal has a focused opportunity to assess risks that are more readily identifiable.”78 The “agent bears the burden of establishing that the requirements stated in this section have been fulfilled.”79
If the Covenant addressed an agency relationship in which the Funds acted as principals and Rich and his affiliates and associates acted as agents, then the Covenant would not be facially invalid. Rich openly sought the Funds’ consent to effectuate a Drag-Along Sale in a setting where it was clear what he wanted to accomplish. As sophisticated investors, the Funds knew what was being asked of them. The Drag-Along Sale was specific transaction that reasonably be expected to occur in the ordinary course of the relationship. Although a sale of the Company is not generally an ordinary course transaction for the Company itself, it is the ever-present goal for venture capital investors.80
In VC heaven, successful exits are ordinary course events. The Funds had wanted a liquidity event and knew that Rich would want one too. In this setting, the Drag-Along Sale was not a breach of duty, and the Covenant again becomes a belt-and-suspenders provision that adds an obligation not to sue where a court applying agency law would find no claim.
The examples from trust and agency law indicate that if judged by traditional standards
2. Delaware Corporate Law And Fiduciary Tailoring
The next question is whether Delaware corporate law has restricted the traditional space for fiduciary tailoring. Delaware corporate law is popularly understood to impose mandatory fiduciary duties that cannot be modified. Although monetary liability for the duty of care can be eliminated, the underlying duty cannot be altered, and the duty of loyalty stands inviolate. That view gains currency from contrasting Delaware corporations with alternatives entities, where the governing statutes authorize the full elimination of fiduciary duties. While it is true that Delaware corporate law has not forged as far afield as its alternative-entity brethren, the corporate form has not rejected the traditional methods of fiduciary tailoring. To the contrary, both the DGCL and Delaware common law accommodate the traditional forms, and the common law has gone further through a concept of contractual preemption articulated most prominently in Nemec v. Shrader.81
a. Statutorily Authorized Tailoring
Sections 102(b)(7) and 122(17) are the two widely acknowledged paths for fiduciary tailoring in the DGCL. Upon closer review, those are not the only routes that the DGCL makes available.
i. Section 102(b)(7)
The most well-known provision in the DGCL that permits fiduciary tailoring is Section 102(b)(7). It currently provides:
The certificate of incorporation may also contain . . . [a] provision eliminating or limiting the personal liability of a director or officer to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director or officer, provided that such provision shall not eliminate or limit the liability of:
- (i) A director or officer for any breach of the director‘s or officer‘s duty of loyalty to the corporation or its stockholders;
- (ii) A director or officer for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law;
- (iii) A director under
§ 174 of this title;- (iv) A director or officer for any transaction from which the director or officer derived an improper personal benefit; or
- (v) An officer in any action by or in the right of the corporation.82
The five exclusions thus prevent a charter provision from eliminating monetary liability for breaches of the duty of loyalty, including its subsidiary requirement that a fiduciary must act in good faith. For directors, the combination of exclusions only permits a charter provision to eliminate monetary liability for breaches of the duty of care. For officers, the combination of exclusions only permits a charter provision to eliminate monetary liability to the stockholders for direct claims for breaches of the duty of care.
Section 102(b)(7) does not speak directly to the Covenant because the statute addresses the extent to which the constitutive documents of the corporation can limit
As discussed below, the structure of the DGCL demonstrates that stockholders have greater freedom to enter into private agreements that constrain their stockholder-level rights than what can be accomplished in the charter and bylaws.84 Because of the distinction between a private stockholder agreement and a provision that appears in the charter or bylaws. Section 102(b)(7) does not render the Covenant facially invalid.
Conversely, Section 102(b)(7) does provide some signals about what stockholders can agree to in a stockholder-level agreement. To the extent a particular measure can appear in the more restricted domain of the charter or bylaws, then stockholders should be able to restrict themselves to at least the same degree in a stockholder-level agreement.
By analogy to Section 102(b)(7), a covenant in a stockholder-level agreement in which the signatories agreed not to assert claims for breach of the duty of care is not contrary to Delaware public policy. The analogy to Section 102(b)(7) also indicates that, relatively speaking, Delaware law is less concerned about limiting liability for direct claims than for derivative claims. Section 102(b)(7)‘s approach to officers illustrates the distinction, because Section 102(b)(7) authorizes a provision that limits or eliminates monetary liability for direct care claims while foreclosing similar exculpation for corporate care claims. The Covenant only addresses direct claims, making it relatively more acceptable.
The Covenant extends to all direct claims for breach of fiduciary duty that the Signatories could assert against a Drag-Along Sale. That broad framing includes direct claims for the duty of care, and at least that much of the Covenant should be valid.
By analogy to Section 102(b)(7), a covenant in a stockholder-level agreement in which the signatories agreed not to assert direct claims for breaches of duty based on recklessness are not contrary to Delaware public policy. When analyzing the scope of exculpation under Section 102(b)(7), Delaware cases have held consistently that that gross negligence encompasses recklessness.85 In civil cases not
Because of the Covenant validly forecloses claims for the duty of care, it is not facially invalid. Section 102(b)(7) therefore does not lead ineluctably to illegitimacy. Section 102(b)(7) imposes limitations on what can appear in the charter and bylaws, and it supports inferences about what Delaware law may otherwise permit or foreclose, but it does not answer the question of the Covenant‘s validity. To the contrary, analogies to what Section 102(b)(7) permits in the more constrained context of a charter
ii. Section 122(17)
A second provision in the DGCL that contemplates fiduciary tailoring is Section 122(17). Under that section, every Delaware corporation has the power to
[r]enounce, in its certificate of incorporation or by action of its board of directors, any interest or expectancy of the corporation in, or in being offered an opportunity to participate in, specified business opportunities or specified
classes or categories of business opportunities that are presented to the corporation or 1 or more of its officers, directors or stockholders.89
A claim for usurpation of a corporate opportunity is a claim for breach of fiduciary duty.90 With the adoption of Section 122(17), “Delaware corporations and managers became free to contract out of a significant portion of the duty of loyalty.”91 Not only that, but the opt-out arrangement need not appear in the charter, disconfirming the theory that all forms of fiduciary tailoring must be charter-based. Under Section 122(17), the board of directors can renounce a specified type or class of opportunities by resolution.
Conceptually, Section 122(17) achieves this result by authorizing the board to accelerate a decision it could make once a corporate opportunity arises. A fiduciary that wishes to pursue a corporate opportunity can present it to the board, and if the board renounces the opportunity, then the fiduciary can proceed.92
By authorizing advance renunciations of corporate opportunities, Section 122(17) enables a board to commit in advance to reject a particular type or class of opportunities. In practice, a corporate opportunity waiver functions like a covenant not to sue. “The board‘s authority to govern corporate affairs extends to decisions about what remedial actions a corporation should take after being harmed, including whether the corporation should file a lawsuit against its directors, its officers, its controller, or an outsider.”93 A board can decide whether or not to assert a claim for usurpation of a corporate opportunity. Through a corporate opportunity waiver, the board commits not to assert a claim for usurpation of a corporate opportunity that falls within specified parameters.
The advance renunciation of a specific type of class of corporate opportunities has obvious parallels to the ability of a trust agreement or an agency agreement to authorize a specific transaction that otherwise would constitute a breach of duty. The parallel also explains why the advance renunciation must be narrowly tailored to “specified business opportunities or specified classes or categories of business opportunities.”94
Section 122(17) shows that the DGCL follows trust and agency law by permitting the authorization of specific transactions that otherwise could constitute a fiduciary breach. The Covenant operates at the stockholder level to achieve a comparable result. Section 122(17) is a powerful indication that that the Covenant is not contrary to Delaware public policy and is not facially invalid.
iii. Section 102(a)(3)
A third way the DGCL permits the corporate planners to tailor the powers of corporate fiduciaries and the duties they owe is through a limited purpose clause. A corporation‘s charter must state “[t]he nature of the business or purposes to be conducted or promoted.”95 The DGCL authorizes the charter to say that “the purpose of the corporation is to engage in any lawful act or activity for which corporations may be organized under the General Corporation Law of Delaware,” with the effect that that “all lawful acts and activities shall be within the purposes of the corporation, except for express limitations.”96 Adopting that broad purpose is advisable, because if a corporation has a narrow purpose, then the corporation lacks the power to engage in activities that exceed or fall outside of its purpose, rendering those actions void.97
By denying the corporation the power to engage in acts outside of a narrowly defined purpose and rendering non-compliant acts void, a narrow purpose clause limits the directors’ powers and concomitant duties.98 Absent a narrow purpose
Through this mechanism, a limited purpose clause effectively modifies the orientation of the directors’ fiduciary duties. Rather than being able to seek freely to maximize the value of the corporation, the board‘s options are constrained in a manner that inherently confers benefits on other stakeholders. If, for example, a corporation has the narrow purpose of pursuing only the business of operating a river ferry, then its directors cannot decide to exit that business and construct a toll bridge. In practice, the limitations imposed by the narrow purpose clause confer benefits on other stakeholders, such as workers in the ferry industry, customers who prefer ferries, and suppliers of ferry boats and tools and parts for the ferry industry.
The ability to specify a narrow corporate purpose has clear parallels to the ability of a trust agreement to specify a purpose for the trust or an agency agreement to specify a purpose for the agent. If the agreement creating the fiduciary relationship specifies a narrow purpose for the relationships, then the fiduciary must pursue that purpose selflessly and in a manner that the fiduciary subjectively believes is in the best interests of the beneficiaries, but he the fiduciary cannot deviate from the purpose. The clause thereby both orients the fiduciary‘s duties and constrains the fiduciary‘s freedom of action.
Section 102(a)(3) and the implications of a narrow purpose clause demonstrate that Sections 102(b)(7) and 122(17) do not occupy the field when it comes to fiduciary tailoring. Other means are available. That suggests in turn that the Covenant is not attempting the impermissible and is not facially invalid.
iv. Section 141(a)
The next path for modifying fiduciary duties appears in Section 141(a) itself.101
“The existence and exercise of [the board‘s authority under Section 141(a)] carries with it certain fundamental fiduciary obligations to the corporation and its shareholders.”103 Because the board‘s authority under Section 141(a) provides the foundation for the directors’ fiduciary duties, it follows that modifying the board‘s authority under Section 141(a) should modify the directors’ fiduciary duties.
Many practitioners can recite the first twenty-four words of Section 141(a) by heart. For present purposes, the next sixty-five words are more important. In its entirety, Section 141(a) states:
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. If any such provision is made in the certificate of incorporation, the powers and duties conferred or imposed upon the board of directors by this chapter shall be exercised or performed to such extent and by such person or persons as shall be provided in the certificate of incorporation.104
Section 141(a) thus consists of a grant of authority followed by an exception. The first sentence gives the board nearly plenary authority over the business and affairs of the corporation “except as may be provided otherwise in this chapter or in its certificate of incorporation” (the “Board Power Exception“).105 The Board Power Exception authorizes modifications to the board-centric regime that appear in the DGCL (“in this chapter“) or the charter (“in its certificate of incorporation“). The second sentence confirms that if a modification appears it the charter, then the board‘s powers and duties “shall be exercised
The Board Power Exception hearkens back to Section 102(b)(1), which states:
Any provision for the management of the business and for the conduct of the affairs of the corporation, and any provision creating, defining, limiting and regulating the powers of the corporation, the directors, and the stockholders, or any class of the stockholders, or the governing body, members, or any class or group of members of a nonstock corporation; if such provisions are not contrary to the laws of this State.107
This provision explicitly authorizes a provision “defining, limiting and regulating the powers of . . . the directors.” In Salzberg, the Delaware Supreme Court interpreted Section 102(b)(1) as “broadly enabling,” with the only limitation found in the phrase “if such provisions are not contrary to the laws of this State.”108 Under this standard, a charter may depart from the common law “provided that it does not transgress a statutory enactment or a public policy settled by the common law or implicit in the General Corporation law itself.”109 In Manti, the Delaware Supreme Court reiterated that the “public policy favoring private ordering” reflected in Section 102(b)(1) “allows a corporate charter to contain virtually any provision that is related to the corporation‘s governance,” subject only to the requirement that it not be “contrary to the laws of this State.”110
The Board Power Exception treats provisions that appear in the DGCL or in the charter as equally effective for tailoring the board‘s power and authority. It follows that extant statutory provisions should provide insight into what types of charter-based modifications are permissible and consistent with public policy.
One statutory exemplar appears in in Subchapter XIV of the DGCL, titled Close Corporations,111 and authorizes a close corporation to provide for management by its stockholders.112 When a corporation elects to be a close corporation and for the stockholders to manage some or all aspects of its business and affairs, the Board Power Exception comes into play to eliminate any conflict with Section 141(a) and confirm that the “business and affairs of [the] corporation . . . shall be managed . . . as . . . otherwise provided in this chapter.”113 Because the Board Power Exception treats statutory provisions and charter provisions as equally effective, charter-based allocations of the board‘s authority should be similarly permissible.
A second statutory exemplar also appears in Subchapter XIV and authorizes the holders of a majority of the outstanding stock entitled to vote in a close corporation to enter into a written agreement among themselves or with another party to “restrict or interfere with the discretion or
A third statutory exemplar appears in Subchapter XV of the DGCL, Public Benefits Corporations, where Section 361 authorizes the charter of a public benefit corporation to identify a public benefit, with the effect that the corporation “shall be managed in a manner that balances the stockholders’ pecuniary interests, the best interests of those materially affected by the corporation‘s conduct, and the public benefit or public benefits identified in its certificate of incorporation.”118 Both the authority provided for narrow purpose provisions in Section 102(a)(3) and the Board Power Exception suggest that a comparable charter provision would be permissible. This decision has already discussed how a narrow purpose provision can channel a board‘s power and associated fiduciary duties to confer benefits on stakeholders. The Board Power Exception provides a route for orienting fiduciary duties explicitly.
The ability to tailor a board‘s authority and concomitant fiduciary duties using the Board Power Exception parallels the ability of a trust agreement to provide specific instructions to the trustee or to name specific beneficiaries whose interests the trustee must serve. It likewise parallels the ability of an agency agreement to provide specific instructions to an agent, including parameters for carrying out the agent‘s duties. Those fiduciary antecedents and existence of the statutory exemplar in Section 361 suggest other possible use cases, such as shifting the fiduciary maximand from equity value to enterprise value,119 or authorizing conditions for a board to extend a dual-class capital structure beyond an existing sunset without generating a loyalty issue that would trigger entire fairness review.120 The Board Power Exception shows that the DGCL provides greater space for fiduciary tailoring than is commonly understood.121
Except where explicit restrictions apply, the chartering power under the DGCL would seem co-extensive with the chartering power that the General Assembly could exercise by special act. From that standpoint, the fact that the General Assembly enacted subchapters of the DGCL that confirmed the ability of corporate planners to use the DGCL to charter close corporations and public benefit corporations eliminated any doubt on that subject, but it does not imply that the power did not already exist. Section 102(a)(3), and the Board Power Exception, and Section 102(b)(1) indicate that it did.
This court‘s decision in eBay Domestic Hldgs., Inc. v. Newmark, 16 A.3d 1 (Del. Ch. 2010), is not to the contrary. There, the court rejected an attempt by corporate fiduciaries to operate a Delaware corporation for an eleemosynary purpose:
The corporate form in which craigslist operates, however, is not an appropriate vehicle for purely philanthropic ends, at least not when there are other stockholders interested in realizing a return on their investment. Jim and Craig opted to form craigslist, Inc. as a for-profit Delaware corporation and voluntarily accepted millions of dollars from eBay as part of a transaction whereby eBay became a stockholder. Having chosen a for-profit corporate form, the craigslist directors are bound by the fiduciary duties and standards that accompany that form. Those standards include acting to promote the value of the corporation for the benefit of its stockholders. The “Inc.” after the company name has to mean at least that.
Id. at 34. The charter of craigslist did not contain a narrow purpose clause or a provision that sought to deploy the authority provided by the Board Power Exception or Section 102(b)(1) to reorient the board‘s fiduciary duties. The controllers of the corporation simply asserted that they were pursuing a philanthropic purpose, which was a confession as stark as Henry Ford‘s insistence on benefiting his workers. Dodge v. Ford Motor Co., 170 N.W. 668, 683–84 (Mich. 1919); see M. Todd Henderson, The Story of Dodge v. Ford Motor Company: Everything Old Is New Again, in Corporate Law Stories 37–76 (J. Mark Ramseyer ed., 2009). Without any charter-based fiduciary tailoring, the eBay analysis is spot on.
v. Section 145
The next DGCL provision does not accommodate fiduciary tailoring, but rather authorizes limitations on fiduciary accountability. Section 145 permits a Delaware corporation to provide indemnification and obtain insurance. Exculpation, indemnification, and insurance are means of protecting fiduciaries against the consequences
The parameters of Section 145 provide insight into the limits of Delaware public policy for loyalty breaches. Section 145(a) addresses indemnification for direct claims and authorizes a corporation to indemnify a director or officer for “expenses (including attorneys’ fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by the person in connection with such action, suit or proceeding,” as long as “the person acted in good faith and in a manner the person reasonably believed to be in or not opposed to the best interests of the corporation.”124 A corporation thus can indemnify a fiduciary for all expenses, including a judgment, incurred for a direct claim for a loyalty breach, as long as the fiduciary acted in good faith and reasonably believed that the decision was not opposed to the
[t]he termination of any action, suit or proceeding by judgment, order, settlement, conviction, or upon a plea of nolo contendere or its equivalent, shall not, of itself, create a presumption that the person did not act in good faith and in a manner which the person reasonably believed to be in or not opposed to the best interests of the corporation.125
Like Section 145(a), the Covenant addresses direct claims. By analogy to Section 145(a), the Covenant could operate as a permissible limitation on fiduciary accountability as long as it does not foreclose a claim where the fiduciary acted in bad faith or had an unreasonable belief that the decision could be at least not opposed to the interests of the corporation. The defendants in this case undoubtedly will argue (and intimated in briefing the motion to dismiss) that they acted in good faith both when engaging in the Interested Transactions and when effectuating the Drag-Along Sale. The possibility that the Covenant could operate validly to foreclose that type of claim indicates that it is not facially invalid.
For purposes of insurance, Section 145(g) does not impose any limitations.126 Recent amendments to Section 145(g) permit a corporation to form its own captive insurer and provide insurance for all claims except “(i) personal profit or other financial advantage to which such person was not legally entitled or (ii) deliberate criminal or deliberate fraudulent act of such person, or a knowing violation of law by such person.”127 By analogy to Section 145(g), the Covenant could operate as a permissible limitation on fiduciary accountability as long the Interested Transactions and the Drag-Along Sale did not confer a “personal profit” to which the defendants “were not legally entitled,” and as long as the defendants did not deliberately act with criminal or fraudulent intent. The possibility that the Covenant could operate validly to foreclose claims under those circumstances indicates that it is not facially invalid.
Section 145 does not speak directly to the Covenant, but by authorizing significant protection against some types of loyalty breaches, it suggests that much of the scope of the Covenant falls within the boundaries of Delaware public policy. Section 145 thus indicates that the Covenant is not facially invalid.
vi. Litigation-Limiting Provisions
Finally, two provisions in the DGCL limit claims for breach of fiduciary
A second litigation-limiting provision is Section 367, which appears in Subchapter XV addressing Public Benefit Corporations. That section states:
Any action to enforce the balancing requirement of § 365(a) of this title, including any individual, derivative or any other type of action, may not be brought unless the plaintiffs in such action own individually or collectively, as of the date of instituting such action, at least 2% of the corporation‘s outstanding shares or, in the case of a corporation with shares listed on a national securities exchange, the lesser of such percentage or shares of the corporation with a market value of at least $2,000,000 as of the date the action is instituted.130
The plain language of the ownership requirement applies even if the wrong involves a loyalty breach or bad faith conduct. For public benefit corporations, Section 367 operates as a covenant not to sue unless the stockholder can meet the ownership threshold.
Sections 327 and 367 demonstrate that Delaware law does not prohibit limitations on loyalty claims. Both sections apply to all stockholders and encompass all claims for breach of fiduciary duty, regardless of subject matter. The Covenant is far narrower: It only restricts the Signatories and only applies to a Drag-Along Sale. Compared to Sections 327 and 367, the Covenant attempts less. The presence of Sections 327 and 367 in the DGCL indicate that the Covenant is not facially invalid.131
The preceding discussion addressed statutorily authorized paths for fiduciary tailoring. The common law goes further and authorizes outcomes comparable to what the Covenant achieves. The existence of common law doctrines that authorize similar outcomes strongly indicates that the Covenant is not facially invalid.
i. Contractual Preemption Of Fiduciary Claims
One powerful common law doctrine asserts that contractual obligations preempt overlapping fiduciary duty claims that arise out of the same set of facts. In Nemec, the leading case, the Delaware Supreme Court stated:
It is a well-settled principle that where a dispute arises from obligations that are expressly addressed by contract, that dispute will be treated as a breach of contract claim. In that specific context, any fiduciary claims arising out of the same facts that underlie the contract obligations would be foreclosed as superfluous.132
The stockholder plaintiffs contended that the defendant directors acted in their own self-interest when they caused the corporation to exercise a contractual right to redeem the plaintiffs’ shares. By exercising the redemption right, the directors deprived the plaintiffs of greater consideration from a then-anticipated transaction.133 The consideration went to the remaining stockholders, including the directors. The Delaware Supreme Court held that the contractual right preempted the fiduciary claim.134
Other decisions likewise hold that a claim for breach of contract occupies the field and preempts overlapping claims for breach of duty against corporate fiduciaries.135 For example, when addressing the
Under Delaware law, if the contract claim addresses the alleged wrongdoing by the director, any fiduciary duty claim arising out of the same conduct is superfluous. The reasoning behind this is that to allow a fiduciary duty claim to coexist in parallel with a contractual claim, would undermine the primacy of contract law over fiduciary law in matters involving contractual rights and obligations.136
The court posited that fiduciary duty claims could only persist under “a narrow exception” that applies when “there is an independent basis for the fiduciary duty claims.”137
If Delaware law were to retreat from the contractual preemption of overlapping fiduciary claims, at least in the corporate context, that would not render the Covenant facially invalid. Through the Covenant, the Funds agreed not to exercise a stockholder right (the right to sue for breach of duty) that they could freely decline to assert. If the underlying right is preempted, then the Covenant is redundant and inoffensive. If the underlying right is not preempted, then the Funds still can commit not to exercise it.
ii. Advance Ratification
The next common law doctrine is ratification, which permits stockholders to extinguish a claim for breach of fiduciary duty by authorizing an act that otherwise would constitute a breach. When a corporation does not have a controlling stockholder, a fully informed, non-coerced stockholder vote cleanses an interested transaction and changes the standard of review from entire fairness to an irrebuttable version of the business judgment rule where the only remaining challenge is waste.138
Stockholders can ratify specific types or classes of interested transactions in advance. The clearest example involves directors setting their own compensation, which is a self-dealing transaction implicating the duty of loyalty such that the directors bear the burden of showing that their compensation is entirely fair.139 Directors cannot use advance ratification to give themselves a blank check, nor can they secure broad authority subject only to a cap. They can, however, obtain authorization for specific payments or for the use of a predictable formula.140
The doctrine of advance ratification has obvious parallels to the concept of advance authorization in trust law or agency law. Advance authorization permits a fiduciary to engage in a transaction that otherwise would constitute a breach of duty. Advance ratification does the same thing.
The Covenant functions like advance ratification. Through the Covenant, the
iii. Laches
The final common law doctrine is laches. Unless a tolling doctrine applies or other extraordinary circumstances exist, laches bars a stockholder plaintiff from asserting a claim for breach of fiduciary duty if more than three years have passed since the claim accrued.141 It does not matter whether the claim involves a loyalty breach or bad faith conduct.142
Stated more generally, a stockholder can choose not to assert a claim for fiduciary duty, and if the stockholder waits long enough, the claim is lost. Through the Covenant, the Funds agreed to that outcome in advance. From that standpoint, the Covenant is not facially invalid, but rather unexceptional.
c. Summing Up The Corporate Law Limitations
Delaware corporate law provides more space for fiduciary tailoring than is commonly understood. Several of those paths authorize outcomes comparable to what the Covenant achieves. Section 122(17) authorizes advance renunciation of corporate opportunities, which is equivalent to a covenant not to sue for usurpation of the renounced opportunities. The Covenant operates similarly. The common law doctrine of contractual preemption indicates that the Drag-Along Right may already foreclose a loyalty claim, leaving the Covenant as an unobjectionable add-on. Both the common law doctrine of advance ratification and the Covenant foreclose litigation over a specific transaction. Finally, the comparison to laches shows that the Funds simply agreed in advance to do something they could do of their own volition: give up their claims by declining to sue. These options make it difficult to say that the Covenant violates Delaware public policy and is facially invalid.
3. The Contractarian Framework And Private Ordering
The next step in the analysis is the role of contract. “Contractual and fiduciary relationships are the two dominant legal forms of interaction through which persons can pursue individual and shared interests.”143 Although often perceived as constituting separate domains, the boundaries between the fields are fluid rather than fixed, and the two areas, “while distinctive, are deeply intertwined.”144
a. The Power Of Private Ordering
To say that Delaware prides itself on the contractarian nature of its law risks understatement:
This jurisdiction respects the right of parties to freely contract and to be able to rely on the enforceability of their agreements; where Delaware‘s law applies, with very limited exceptions, our courts will enforce the contractual scheme that the parties have arrived at through their own self-ordering, both in recognition of a right to self-order and
to promote certainty of obligations and benefits.145
“Sophisticated parties” can and should “make their own judgments about the risk they should bear,” and Delaware courts are “especially chary about relieving sophisticated business entities of the burden of freely negotiated contracts.”146
Within this framework, public policy plays a limited role. “When parties have ordered their affairs voluntarily through a binding contract, Delaware law is strongly inclined to respect their agreement, and will only interfere upon a strong showing that dishonoring the contract is required to vindicate a public policy interest even stronger than freedom of contract.”147 More significant interests “are not to be lightly found, as the wealth-creating and peace-inducing effects of civil contracts are undercut if citizens cannot rely on the law to enforce their voluntarily-undertaken mutual obligations.”148
[T]he right to contract is one of the great, inalienable rights accorded to every free citizen. . . . “If there is one thing more than any other which public policy requires it is that men of full age and competent understanding shall have the utmost liberty of[]contracting” and that this freedom of contract shall not lightly be interfered with. We also recognize that freedom of contract is the rule and restraints on this freedom the exception, and to justify this exception unusual circumstances should exist.149
Delaware courts will “not rewrite the contract to appease a party who later wishes to rewrite a contract he now believes to have been a bad deal. Parties have a right to enter into good and bad contracts, the law enforces both.”150
Delaware‘s embrace of contractarianism extends to the corporate form, where it manifests as the concept of private ordering.151 “Delaware‘s corporate statute is widely regarded as the most flexible in the nation because it leaves the parties to the corporate contract (managers and stockholders) with great leeway to structure their relations, subject to relatively loose statutory constraints and to the policing of director misconduct through equitable review.”152 “Our law strives to enhance flexibility in order to engage in private ordering[, and] our DGCL was intended
The contractarian theory of the corporation envisions the firm as a nexus of explicit and implicit contracts.155 Under the contractarian approach, “[c]orporate law—and in particular the fiduciary principle enforced by courts—fills in the blanks and oversights [in the corporate contract] with the terms that people would have bargained for had they anticipated the problem and been able to transact costlessly in advance.”156 Because fiduciary duties function in this framework as default rules in an otherwise incomplete corporate contact, parties can modify them by agreement. “On this view corporate law supplements but never displaces actual bargains—save in situations of third-party effects or latecomer terms.”157 For the contractarian theory of corporate law, fiduciary duties are not immutable, mandatory terms but rather freely modifiable defaults.158
When it comes to corporate theory, I am not a contractarian. My conception of the corporation (and entity law generally) starts from the proposition that jural entities like corporations are creations of state power, and they have characteristics that only the state can provide, such as separate legal existence, presumptively perpetual life, limited liability for investors, the ability to contract and own property, and access to the judicial system, which gives them the ability to invoke the power of the state to obtain redress for injuries and enforce commitments. Jural entities are thus never wholly creatures of contract. Nor are they a nexus of contracts. However attractive that metaphor might be for economic modeling, entities are reified constructs. It is only because they are reified (personified) that they can move through the legal landscape.
This is a type of concession theory. See Manesh, supra, 535–47. But concession theory is only a starting point, because it leaves open the question of what the state has created when it charters an entity. The answer is an autonomous form of intangible property, with biological humans serving as the ghost in the machine that enables the form of property to engage with the world. Someday, artificial intelligence may animate corporations, but for now only biological humans can make decisions on their behalf and cause them to act. The resulting theory of the corporation starts with concession theory and adds a superstructure of property rights, so let‘s call it modern concession theory (MCT).
Because of the state‘s role in creating, maintaining, and eventually terminating the entity, the state has a persistent policy interest in establishing its characteristics, including what the entity can do and how it operates. But the state‘s persistent policy interest does not mean that MCT carries a pre-determined set of political commitments. Different
jurisdictions can charter entities with different public policy visions. Delaware charters entities with a vision of providing significant freedom for private ordering, which MCT easily accommodates. Unlike contractarianism, MCT also explains why the state can and does impose limits on private ordering. See Manesh, supra, at 539 (describing MCT’s ability to explain “facets of contemporary corporate law that conflict with pure contractarianism,” including a “mandatory fiduciary duty of loyalty“); see also In re Coinmint, LLC, 261 A.3d 867, 908–13 (Del. Ch. 2021) (discussing role of state in creating a jural entity and its implications for a jurisdiction’s power to dissolve an entity created by another state).
While accommodating private ordering, MCT acknowledges limitations on what a state can use entity law to accomplish. See Manesh, supra, at 541–43. Because an entity is a form of autonomous property that the state creates, the state can define its attributes, the interrelationships among its component parts, and the internal processes by which it acts (or the methods by which parties can select attributes, form interrelationships, and establish internal processes). The state does not, however, act in a vacuum. Just like real property in the physical world, an autonomous entity has borders, and there can be other jurisdictions on the other side of those borders. In those situations, the requirements for passage must be co-created with other sovereigns. Our neighbor to the north can determine what is required to enter Canadian soil, but the United States can dictate what is required to leave American soil. There are also senior sovereigns whose law dominates (preempts) the law of junior sovereigns. Within our own republic, the United States Constitution and the protection for interstate travel secured by
The concepts of borders and trans-border domains provide helpful analogies for the limits on what a state can regulate through its power to create an entity. Consider the limits on a state’s ability to regulate real property. Even if the General Assembly enacted legislation that purported to govern all of the Delmarva peninsula, those statutes would have no effect south of the Transpeninsular Line, east of the low tide mark of the Delaware River, or west of Tangent Line.
The contrast between the Delaware Supreme Court’s decision in Salzberg and my trial-level ruling illustrates how contractarianism and MCT can lead to different results. The Delaware Supreme Court grounded its analysis on
By treating
As Professor Manesh has noted, the Delaware Supreme Court’s embrace of contractarianism in Salzberg has broad implications. See Manesh, supra, at 547–75. For purposes of the Covenant, I do not perceive any conflict between what MCT calls for and what contractarianism would envision. The Covenant appears in a bargained-for agreement between contracting parties and is thus comparable to Rodriguez. The agreement addresses a stockholder right appurtenant to the shares that the Funds owned as their private property. The limitations on state power implied by MCT do not restrict the ability of stockholders to make contractual commitments regarding property rights that they could otherwise freely exercise over a stockholder’s ability to assert a specified type of claim for breach of fiduciary duty. The Covenant is therefore not facially invalid.
b. Private Ordering And Stockholder Agreements
Delaware’s commitment to contractarianism should be at its height when stockholders enter into agreements about how they will exercise stockholder-level rights, because at that level, individual owners are bargaining over their private property. Consistent with that intuition, the DGCL demonstrates that stockholders can agree to greater constraints on their rights in a stockholders agreement than a corporation can impose in its charter or bylaws. As long as the contractual provision addresses a type of action that one stockholder or a group of stockholders can take, then there is greater space for private ordering, not less, when the provision appears in a stockholders agreement. The Covenant appears in a stockholder-level agreement, providing further support for the conclusion that it is not facially invalid.
“A share of stock represents a bundle of rights defined by the laws of the chartering state and the corporation’s certificate of incorporation and bylaws.”160 By statute, a share of stock is the personal property of its owner.161 The rights associated with and appurtenant to a share of stock are therefore rights that the owner can freely exercise or decline to exercise. Three rights are viewed as fundamental: the rights to sell, vote, and sue.162
Delaware law permits stockholders to contract over their right to sell:
A restriction on the transfer or registration of transfer of securities of a corporation, or on the amount of a corporation’s securities that may be owned by any person or group of persons, may be imposed . . . by an agreement among any number of security holders or among such holders and the corporation.163
Delaware law specifically permits stockholders to (i) grant a right of first refusal on shares in favor the corporation or any person,164 (ii) grant a right to purchase or sell the shares to the corporation or any person,165 (iii) agree to obtain the consent of the corporation or the holders of any class or series of securities before selling shares,166 (iv) commit to sell or transfer the shares to the corporation or any person,167 and (v) restrict or prohibit the transfer of shares to designated persons, as long as the designation is not manifestly unreasonable.168 Delaware law expansively permits “any other lawful restriction on transfer or registration of the restricted securities, or on the ownership of the restricted securities by any person.”169 The DGCL thus authorizes a stockholder to covenant not to sell.
An agreement between 2 or more stockholders, if in writing and signed by the parties thereto, may provide that in exercising any voting rights, the shares held by them shall be voted as provided by the agreement, or as the parties may agree, or as determined in accordance with a procedure agreed upon by them.170
The DGCL thus authorizes a stockholder to covenant not to vote.
The DGCL confirms that a stockholder has greater freedom to restrict its rights to vote or sue in a private agreement than a corporation can impose through its charter or bylaws. For the right to sell,
A similar structure exists for the right to vote. The DGCL requires that any “qualifications, limitations or restrictions” on the powers associated with a share of stock appear in the charter.173 The power to vote is a power associated with a share of stock.174 Through the charter, a corporation can create shares with or without voting rights or with tailored voting rights.175 What the corporation cannot do through its charter is dictate how individual stockholders exercise their voting rights Yet through a voting agreement, stockholders can bind themselves to vote or not vote to any degree imaginable.176
The different levels of permissible constraints comport with the doctrine of independent legal significance.
[T]he general theory of the Delaware Corporation Law is that action taken under one section of that law is legally independent, and its validity is not dependent upon, nor to be tested by the requirements of other unrelated sections under which the same final result might be attained by different means.177
To state the obvious, a stockholders agreement is not a charter or bylaw provision, so restrictions on charter or bylaw provisions do not govern stockholders agreements.
The different levels of permissible constraint reflect different levels of consent.178
- A provision in a pre-IPO charter does not receive express approval from the publicly held shares. Holders of shares become bound when they buy shares, making their consent implicit. The
same is true in a private company for the original charter.179 - Under the DGCL, a midstream charter amendment requires both approval from the board and approval by the holders of a majority of the outstanding voting power of the corporation.180 The adoption of a midstream charter amendment means that holders of a majority of the outstanding voting power have consented to it, which indicates some level of consent.181 But “any shareholder who did not vote in favor of the midstream amendment did not consent at all. . . . At most, such a shareholder consented to the rules for changing [the] charter . . . (to the extent these rules were established when the company initially sold the shares).”182 A midstream charter amendment binds stockholders regardless of actual consent.
- Under the DGCL, a bylaw amendment provides ambiguous indications of consent. The board and the stockholders can typically each adopt, amend, alter, or repeal bylaws unilaterally.183 If a board implements a bylaw, then stockholders are bound without any affirmative act of consent, other than having accepted the rules for amendment.184 But because stockholders can amend the provision without board approval, the continued presence of the bylaw provides some indication of stockholder consent.185
None of these forms of consent resembles what contract law traditionally contemplates.186
By contrast, when stockholders execute a stockholder-level agreement, they provide the level of consent that contract law traditionally contemplates, which in turn supports greater freedom to allocate rights.
At this point in the analysis, confusion can arise because of the hierarchy of authorities that govern a corporation. As I have written elsewhere,
When evaluating corporate action for legal compliance, a court examines whether the action contravenes the hierarchical components of the entity specific corporate contract, comprising (i) the Delaware General Corporation Law, (ii) the corporation’s charter, (iii) its bylaws, and (iv) other entity specific contractual agreements, such as a stock option plan,
other equity compensation plan, or, as to the parties to it, a stockholder agreement.187
“Each of the lower components of the contractual hierarchy must conform to the higher components.”188
When does a provision in a stockholders agreement conflict with the DGCL, the charter, or the bylaws such that the higher-level component overrides it? The DGCL, charter, and bylaws establish the rights that stockholders possess. If the stockholder-level agreement binds the stockholders as to how they exercise those rights, then there is no conflict. But if a stockholders agreement purports to alter or ignore the structure that the higher-level components created, then the effort is ineffective, and the higher-level component prevails.189
Take a provision in a stockholders agreement that attempts to define the number of directors comprising the whole board.
Schroeder v. Buhannic191 provides a more complex illustration. The stockholders committed in a voting agreement to elect the following directors: (i) three designated by the holders of a majority of the common stock, one of whom shall be the CEO, (ii) two designated by the holders of a majority of the preferred stock, and (iii) two independent, non-employee directors selected by the holders of a majority of the common stock and approved by the holders of a majority of the preferred stock. The stockholders disagreed over whether the common stockholders could select the CEO, at which point the signatory stockholders had to vote for him as one of the three directors designated by the common stock, or whether the board selected the CEO, at which point the common stockholders had to designate him as one of their directors.192 Appointing a CEO is a core board function, and the bylaws provided that the board selected the CEO, so the voting agreement could not override that allocation of authority. It followed that the board had the power to identify the CEO, the common stockholders bound themselves to name him as one of their three designees, and all of the signatory stockholders bound themselves to vote for him.193
These principles point to a simple test for determining whether a provision in a
By analogy to the right to vote and the right to sell, limitations on the right to sue that appear in the charter or bylaws should be more suspect than limitations in a stockholders agreement. Once the DGCL, charter, and bylaws have established the rights appurtenant to the shares, including the rights that a stockholder can sue to enforce, the stockholder should be relatively unconstrained freedom to contract about asserting those rights. Just as a stockholder can covenant not sell or vote, a stockholder should be able to covenant to not sue. This reasoning suggests that the Covenant is not facially invalid.
E. Other Considerations
The preceding tour through traditional fiduciary law, the DGCL, Delaware corporate law, and Delaware’s support for private ordering indicates that the Covenant is not facially invalid. But to hold that stockholders in a Delaware corporation can commit not to sue for breach of fiduciary duty is a significant step, so it is worth considering other possible arguments against it. This section considers (i) whether the right to sue for breach of fiduciary duty is too big to waive, (ii) whether enforcing a provision like the Covenant threatens Delaware’s corporate brand, (iii) whether upholding a provision like the Covenant collapses the distinction between corporations and LLCs, and (iv) the majority and dissenting opinions in Manti. Those considerations do not support declaring the Covenant facially invalid.
1. Is A Claim For Breach Of Fiduciary Duty Too Big To Waive?
An intuitively attractive argument for declaring the Covenant facially invalid is that a claim for breach of fiduciary duty is simply too important to waive. One way to evaluate that contention is to consider what other rights are waivable.194
Delaware law permit individuals to waive fundamental rights associated with their personal liberty:
- Both the United States Constitution and the Delaware Constitution guarantee a criminal defendant the right to trial by jury.195 That right can be waived.196
- Both the United States Constitution and the Delaware Constitution provide a criminal defendant with a right to be present for trial and confront the witnesses
against him.197 That right can be waived.198 - Both the United States Constitution and the Delaware Constitution provide a witness with a right to counsel in a criminal case.199 That right can be waived.200
- Both the United States Constitution and the Delaware Constitution protect against self-incrimination.201 That right can be waived.202
- A criminal defendant can waive all of his rights to personal liberty by entering a guilty plea, freely and voluntarily.203
As the Delaware Supreme Court has observed, “Clearly, our legal system permits one to waive even a constitutional right.”204
Delaware law permits individuals to waive important rights associated with their property. A waiver of a property right is generally effective so long as it is voluntary, knowing, and intelligently made, or reflects an intentional relinquishment or abandonment or of a known right or privilege.205 For example, under the Due Process Clause of the
Delaware law generally permits individuals to waive statutory rights.209 Real property owners can agree
It is not self-evident why Delaware law would afford greater protection to a property interest associated with a share of stock that enables the owner to sue for breach of fiduciary duty than it does for those fundamental liberty and property interests. A comparison to what else individuals can waive suggests that the Covenant is not facially invalid.
2. The Threat To Delaware’s Corporate Brand
A rhetorically powerful argument for declaring the Covenant facially invalid asserts that it would undermine Delaware’s corporate brand. In a well-known article, two practitioners argue that Delaware offers a corporate product that comes with commonly understood attributes, including mandatory and generally immutable fiduciary duties.213 Although the authors did not address stockholder-level agreements, the branding argument posits that to permit a stockholder to waive a mandatory feature of Delaware law would undermine the common understanding of a Delaware corporation. Therefore, the argument goes, a provision like the Covenant should be invalid. While maintaining the value of Delaware’s corporate brand is important, it does not call for invalidating a private agreement in which stockholders make commitments about how to exercise their stockholder-level rights.
The argument about Delaware’s corporate brand stresses the benefits of standardization.214 There are benefits from standardized roles and relationships, because standardization reduces transaction costs, creates shared understandings, influences conduct, and enables the law to promote values beyond efficiency.215
Delaware’s embrace of private ordering already goes a long way towards limiting the benefits of standardization for Delaware corporations. A prudent investor must review the charter and bylaws to understand the rights appurtenant to the corporation’s shares and any limitations
The practitioners who emphasize brand value argue that mandatory terms are nevertheless essential to Delaware’s corporate brand:
Merely by branding itself as a Delaware corporation, a firm can signal easily that it has certain core characteristics that provide basic protections to investors. Anyone contemplating buying shares of stock in a Delaware corporation can be confident, without having to obtain and examine the certificate of incorporation, that the directors of the corporation will be subject to a duty of loyalty; that stockholders will have the right to inspect corporate books and records for a proper purpose; and that the stockholders will have the right, periodically, to elect the directors.216
True, an investor need not review the certificate or bylaws to confirm those three features, but an investor needs to examine the charter and bylaws to assess all of the other features that can change. Tellingly, the authors spend much of their article discussing the considerable space for private ordering that the DGCL provides.217
When turning to the rare mandatory features in the DGCL, the authors focus exclusively on what corporate planners cannot modify in the charter or bylaws.218 They do not make claims about what stockholders can agree to in stockholder-level agreements. That editorial decision is understandable, because stockholder-level agreements do not alter the rights that the DGCL, charter, and bylaws bestow. Through a stockholder-level agreement, stockholders can make commitments about how they exercise their rights, but they cannot change those rights. A stockholder-level agreement only binds its signatories, and other stockholders remain free to exercise their rights differently. Even if some of the stockholders have entered into agreements among themselves, it remains true that “[a]nyone contemplating buying shares of stock in a Delaware corporation can be confident, without having to obtain and examine the certificate of incorporation, that the directors of the corporation will be subject to a duty of loyalty; that stockholders will have the right to inspect corporate books and records for a proper purpose; and that the stockholders will have the right, periodically, to elect the directors.”219
That said, some stockholder-level agreements are sufficiently weighty that they can affect the shared expectations created by the corporation’s constitutive documents. When a critical mass of stockholders have bound themselves to exercise their stockholder-level rights in a particular way, then their agreement can exert a gravitational pull that distorts the corporate governance space. Most stockholder-level agreements do not have that effect. A proxy is a stockholder-level agreement, and the vast majority of proxies are routine. A call or put option is a stockholder-level agreement, and those are mostly routine as well. The agreement that creates a
Investors should know about consequential stockholder-level agreements.221 The logical answer to non-disclosure is not to invalidate the agreements, but to require disclosure. The DGCL could state that a stockholder agreement meeting certain criteria is only enforceable if a copy is provided to the corporation, which then must either (i) file the agreement or a summary with the Delaware Secretary of State or (ii) note its existence on the stock ledger and make it available for inspection upon request. The DGCL already takes the former course for merger agreements222 and the latter for voting trust agreements.223 It would be important to craft the criteria with care, because so many stockholder-level contracts do not warrant that treatment.
For purposes of a Delaware corporation, a stockholder-level agreement that allocates how stockholders exercise their rights is on-brand, not off. Private ordering and fiduciary accountability are key components of Delaware’s corporate brand. A stockholder-level agreement is a quintessential form private ordering, because it involves stockholders making commitments about their own rights. Other stockholders remain free to exercise their rights as they wish, including by exercising their rights to pursue corporate accountability.
This case involves two key elements of Delaware’s corporate brand, so an appeal to brand value is unlikely to be dispositive. An advocate could assemble citations suggesting that one policy or the other is more important, but the result would reveal more about the research team’s skill than the relative importance of the policies. Because brand value is elusive,224 appeals to brand value could lead to broad normative claims, less emphasis on traditional authorities, and the possibility that personal preferences sneak into the analysis.
assess which features are mandatory, they rely on traditional legal authorities.227 Even for them, brand value is not an input, but an output. It is not a means of determining which aspects of Delaware‘s corporate regime cannot be tailored; it is the result of making that determination by other means.
There may be cases where considering brand value might be helpful. Particularly when aspects of brand value are easily identified and all point in the same direction, then referring to brand value could provide support for an outcome. In this case, two core components point in opposite directions, making brand value too uncertain to use as a tiebreaker. The argument about Delaware‘s corporate brand does not warrant holding the Covenant facially invalid.
3. Corporate Law As LLC Law
Another rhetorically powerful argument for declaring the Covenant facially invalid asserts that to permit stockholders to waive claims for breach of fiduciary through a private agreement would blur the distinction between corporations and LLCs. There is value in distinguishing between the two types of entities, but stockholder-level contracting about stockholder-level rights does not collapse the divide.
For starters, the line between corporate law and LLC law is already blurred, albeit from the other side. Decisions frequently observe that LLCs “are creatures of contract,”228 which they primarily are.229 The
Returning to the corporate side of the divide, a stockholder-level agreement does not risk blurring the distinctions between the entities, because those distinctions exist at the level of the governing statutes and the constitutive documents.233 Regardless of what investors might agree to in investor-level agreements, there are fundamental differences between what a certificate of formation must contain (virtually nothing) and what a certificate of incorporation must contain (six enumerated items including the number and types of shares the corporation can issue and any special rights, powers, privileges, qualifications, and limitations on those shares).234 And there are fundamental differences between what an LLC can achieve through its constitutive document (minimally constrained) and what a corporation can achieve (moderately constrained). Most notably, the constitutive document of an LLC (the LLC agreement) can (i) fully eliminate any duties existing at law or in equity, including fiduciary duties,235 (ii) provide indemnification and
Those profound differences make LLCs and corporations resolutely different things. Those differences remain even though each type of entity confers bundles of rights on investors that manifest as a form of personal property (a member interest or a share).242 Those differences persist when the holders of those investor-level rights (i) decide in real time whether or not to exercise their rights and (ii) make contractual commitments about rights that they otherwise could exercise freely. True, there is a superficial similarity in the ability of both LLC members and stockholders to make exercise-or-refrain decisions and to enter into investor-level agreements about those decisions, but that resemblance does not alter the basal gulf between the underlying forms of state-created property (the entities themselves).243 The argument about collapsing the entity divide is not a basis to declare the Covenant facially invalid.
4. The Opinions In Manti
The majority and dissenting opinions in Manti provide insight into how the Delaware Supreme Court viewed a similar public policy issue. In Manti, the justices considered whether to enforce a covenant not to assert appraisal rights, which the high court labeled the “Refrain Obligation.” Like the Covenant, the Refrain Obligation appeared in a drag-along provision in a voting agreement. As in this case, investment funds who had entered into the voting agreement sought to escape their promise by arguing that the Refrain Obligation was invalid.
The majority opinion in Manti upheld the Refrain Obligation, but it contains language which could be read to suggest that the Covenant is facially invalid. The dissent would have invalidated the Refrain
a. The Manti Majority
The investment funds in Manti advanced two grounds for invalidating the Refrain Obligation. First, they claimed that the provision violated Section 262, which governs appraisal rights. Second, they argued that the provision violated Delaware public policy. A majority of the Delaware Supreme Court rejected both arguments.
The argument for statutory invalidity relied on language in Section 262 stating that “[a]ppraisal rights shall be available for the shares of any class or series of stock of a constituent or converting corporation in a merger or consolidation or conversion [subject to specified exceptions].”244 The investment funds contended that the statute‘s use of the auxiliary verb “shall” meant that appraisal rights were mandatory and could not be waived through a voting agreement. The majority rejected that assertion, citing (i) Delaware‘s public policy in favor of private ordering,245 (ii) the absence of any express prohibition in the DGCL on the waiver of appraisal rights,246 (iii) the general principal that parties can waive mandatory rights,247 and (iv) the fact that the stockholders who signed the agreement were “sophisticated and informed investors, represented by counsel, that used their bargaining power to negotiate for funding . . . in exchange for waiving their appraisal rights.”248 Under the majority‘s reasoning, the DGCL created a stockholder-level right to seek appraisal, and a stockholder could decide whether or not to exercise that right. Just as a stockholder could make that decision in real time, a stockholder could commit in advance to refrain from exercising that right. The Refrain Obligation therefore did not conflict with the DGCL.
The public policy argument for invalidity asserted that appraisal rights were too important for stockholders to waive. The majority rejected that argument as well and deemed the Refrain Obligation enforceable. The reasons the majority offered can be sorted into two categories: responses to a facial challenge, and responses to an as-applied challenge. Under the first heading, the majority observed that (i) appraisal rights did not play “a sufficiently important role in regulating the balance of power between corporate constituencies to forbid sophisticated and informed stockholders from freely agreeing to an ex ante waiver,”249 and (ii) the waiver of appraisal rights was a logical consequence of a drag-along provision, which generally required signatory stockholders to vote for the qualifying transaction and thereby indirectly
At various points in the decision, the majority cited factual considerations that apply equally to the Funds, the defendants, and the Covenant:
- The Funds are “sophisticated investors, represented by counsel, that agreed to a clear waiver of their [right to challenge a Drag-Along Sale] in exchange for valuable consideration.”254
- The Voting Agreement is “not a contract of adhesion.”255
- The Funds “have not argued that they were ignorant of the [Covenant] when they signed the contract or that the inclusion of the [Covenant] was a mistake.”256
- It would have been “easy for the [Funds] to predict the circumstances in which the [Covenant] would be invoked, namely, [Rich] and the board might approve a [Drag-Along Sale].”257
- The Covenant is not being enforced “against a retail investor that was not involved in negotiating the [Voting] Agreement.”258
- The Covenant is not being enforced “against outsiders that lack material knowledge of [the Company‘s] corporate governance dynamics.”259
- The Funds were “insiders for the purpose of negotiating the [Voting] Agreement.”260
- There is no suggestion that Rich “coerced the [Funds] into” agreeing to the Covenant.261
- There is no suggestion that the Funds “did not know that the [Voting] Agreement contained the [Covenant].”262
- There is no suggestion that Rich “had any secret knowledge when [he] negotiated the [Voting] Agreement.”263
- The Funds are “capable investors” who “do not need protection of the courts to escape a bad bargain.”264
- The Covenant does not raise “concerns about a lack of consent.”265
- The Covenant does not involve “enforce[ing] a contract of adhesion against a stockholder that lacked bargaining power
.”266 - The Funds “specifically assented to the [Voting] Agreement.”267
- The Funds were “represented by counsel and had negotiating leverage.”268
- The Funds “freely and knowingly consented to the [Covenant] in exchange for valuable consideration.”269
Through its analysis, the Manti majority built on Salzberg‘s embrace of contractarian principles. But while upholding the Refrain Obligation, the majority cautioned that its decision did not mean that all appraisal waivers were valid:
Allowing [the company] to enforce this Refrain Obligation against these Petitioners does not mean that all ex ante waivers of appraisal rights are enforceable or that the waiver of any other stockholder right would be enforceable. To the contrary, there are other contexts where an ex ante waiver of appraisal rights would be unenforceable for public policy reasons.270
The multi-factor analysis conducted by the Manti majority suggests that if some or all of those factors were absent, then a similar provision would be suspect.
The Manti majority also admonished corporate planners that all stockholder-level rights were not automatically fair game for contractual waivers:
[T]here may be other stockholder rights that are so fundamental to the corporate form that they cannot be waived ex ante, such as certain rights designed to police corporate misconduct or to preserve the ability of stockholders to participate in corporate governance. Allowing [the company] to enforce the Refrain Obligation against the Petitioners does not mean that the ex ante waiver of all other stockholder rights would be enforceable.271
Fairly read, that warning seems to refer to the duty of loyalty, which is “fundamental to the corporate form” and the principal means by which Delaware courts “police corporate misconduct.” The Manti majority did not specifically call out the duty of loyalty, but if not that duty, then what? Not the right to vote for directors or on fundamental transactions like mergers, because the DGCL permits stockholders to constrain their right to vote in a stockholder-level agreement.272 Not the right to sell their shares, because the DGCL permits stockholders to constrain their right to sell in a stockholder-level agreement.273 Perhaps the right to seek books and records,274 but right is instrumental to the ability to exercise other rights, and if a stockholder-level agreement can constrain the ultimate rights, it should be able to constrain the instrumental right. Two Court of Chancery decisions indicate that a stockholder can waive or limit its ability to exercise Section 220 rights through a clear and express provision in a bilateral agreement.275
But that conclusion does not end the analysis, because the justices in Manti also considered a case-specific factors when determining that the Refrain Obligation was not contrary to public policy. Their reasoning indicates that in an as-applied challenge, a court can consider (i) the presence of the provision in a bargained-for contract, (ii) the clarity and specificity of the provision, (iii) the stockholder‘s level of knowledge about the provision and the surrounding circumstances, (iv) the stockholder‘s ability to foresee the consequences of the provision, (v) the stockholder‘s ability to reject the provision, (vi) the stockholders’ level of sophistication, and (vii) the involvement of counsel. Those factors are necessarily illustrative and not exclusive.
The factors that the Manti majority considered all relate to whether it was reasonable to enforce the Refrain Obligation on the facts of the case. The Manti decision thus indicates that to survive an as-applied challenge, the party seeking to enforce a waiver must convince the court that the waiver is reasonable.276
One justice dissented in Manti and would have invalidated the Refrain Obligation. The dissent cited (i) ambiguity in the Refrain Obligation,277 (ii) a mismatch between when the Refrain Obligation terminated and the operation of the appraisal statute,278 (iii) the presence of the Refrain Obligation in a stockholder-level agreement rather than in the corporation‘s constitutive documents,279 (iv) concern about permitting common stockholders to waive appraisal rights,280 (v) concern that permitting waivers of appraisal rights and other mandatory statutory provisions in stockholder agreements “would transform the corporate governance documents into gap-filling defaults and collapse the distinction between a corporation and alternative entities,”281 and (vi) a view that appraisal rights are a mandatory, non-waivable feature of Delaware corporate law because of their historical role in protecting minority stockholders from underpriced transactions.282
The dissent argued convincingly that the Refrain Obligation was ineffective because a drafting bust caused the obligation to terminate before the time came to exercise or waive appraisal rights.283 The dissent also raised an important concern about “stealth” corporate governance arrangements in which significant stockholders enter into stockholder-level agreements governing the exercise of their rights without other stockholders knowing about the agreements or their implications.284 This decision differs only in the response to that concern: It proposes disclosure rather than invalidity.
Otherwise, the dissent took the other side of the arguments considered by the majority. The dissent provided an additional spur for this decision‘s extensive engagement with traditional fiduciary principles, the DGCL, the Delaware common law, and contractarian principles. Only after conducting that analysis has this decision concluded that the Covenant is not facially invalid.
F. The Altor Bioscience Decision
Although the parties did not cite it, a Delaware decision has addressed the validity
Altor Bioscience was a privately held company that was sold to an acquirer. Two stockholders and former directors (Gray and Waldman) asserted claims for breach of fiduciary duty against the fiduciaries who approved the deal. The defendants relied on letter agreements that Gray and Waldman had signed “to broker a ‘peace in the valley,’ in the midst of great tension between two factions of the Altor board.”286 Under the letter agreements, Gray and Waldman resigned from the board and received options and other consideration. In Section 7 of the agreements, Gray and Waldman covenanted that for a period of five years, they would not “directly or indirectly commence, prosecute or cause to be commenced or prosecuted against any Company Releasee any action or other proceeding of any nature before any court, tribunal, Governmental Authority or other body, except for the Company‘s breach of this letter agreement.”287 Vice Chancellor Slights held that this provision was “tantamount to a covenant not to sue” that had been “offered in exchange for valuable consideration” and was enforceable in accordance with its plain and unambiguous terms.288
Gray and Waldman argued that the covenant not to sue was invalid as a matter of public policy because it extinguished claims for breach of the duty of loyalty. In rejecting that argument, Vice Chancellor Slights distinguished between a covenant not to sue that only binds the signatories and a charter provision that purports to limit or eliminate fiduciary duties generally or that seeks to limit or eliminate liability for the duty of loyalty. He explained that a covenant not to sue does not modify either the underlying duty or the availability of a remedy; it only constitutes a commitment by the signatories not to assert the claim.
Vice Chancellor Slights next considered when a covenant might nevertheless operate constructively to limit or eliminate fiduciary duties or the ability to recover damages for a loyalty breach. Relying on Yucaipa American Alliance Fund I, L.P. v. SBDRE, LLC, 2014 WL 5509787, at *15 (Del. Ch. Oct. 31, 2014), he distinguished between a case where all stockholders are signatories, such that no one can sue, and a situation where “others not bound by the contract could bring suit.”290 He concluded that as long as other parties could assert
The ruling in Altor Bioscience anticipates the majority opinion in Manti by declining to hold the covenant facially invalid and instead carefully analyzing whether it was reasonable to enforce the provision. For purposes of a facial challenge, Vice Chancellor Slights noted that the provision did not limit or eliminate the defendants’ fiduciary duties or their liability for breach. The provision only bound the signatories and prevented them
from filing suit. For purposes of the as-applied challenge, Vice Chancellor Slights noted that Gray and Waldman had agreed to the provision to secure a result they desired—peace in the valley—and they accepted consideration in exchange for the agreement that contained the covenant. By filing suit, they were doing precisely what they had agreed in writing not to do.
The discussion of whether other stockholders could sue should be viewed as part of the overarching reasonableness analysis. A critic might interpret the Altor Bioscience ruling as establishing a “Rule of One,” under which if at least one other stockholder could sue, then a covenant would be valid. That would be a caricature. Vice Chancellor Slights considered the extent to which other stockholders could sue. The existence of a single stockholder who could assert a claim would not render a provision reasonable. The Altor Bioscience ruling supports evaluating a provision like the Covenant for its reasonableness.
G. The Case-By-Case Analysis Contemplated By Manti And Altor Bioscience
The decisions in Manti and Altor Bioscience point to a two-step analysis for a provision like the Covenant. First, the provision must be narrowly tailored to address a specific transaction that otherwise would constitute a breach of fiduciary duty. The level of specificity must compare favorably with what would pass muster for advance authorization in a trust or agency agreement, advance renunciation of a corporate opportunity under
Next, the provision must survive close scrutiny for reasonableness. In this case, many of the non-exclusive factors suggested in Manti point to the provision being reasonable. Those factors include (i) a written contract formed through actual consent, (ii) a clear provision, (iii) knowledgeable stockholders who understood the provision‘s implications, (iv) the Funds’
First, the Covenant is an express provision that appears in the Voting Agreement. The Funds executed that contract and agreed to its terms. The Covenant did not appear as a take-it-or-leave-it provision in a pre-IPO charter. Nor was the Covenant imposed through a midstream charter amendment that the Funds voted against. The Funds freely promised in a written agreement that they would not sue over the Drag-Along Sale. For the Funds to disclaim their written promise makes them “liar[s] in the most inexcusable of commercial circumstances: in a freely negotiated written contract.”293
Second, the Covenant is clearly written. No one argues that it does not cover the Sale Counts or the defendants.
Third, the Funds are sophisticated repeat players. They necessarily understood the implications of the Covenant, which tracks language in the NVCA‘s model voting agreement. Discovery might well show that the Funds or their sponsors have deployed comparable provisions to their benefit in other transactions.
Fourth, the Funds could have rejected the Covenant. As the Company‘s largest incumbent investors and holders of preferred stock, the Funds could have blocked the Recapitalization and forced the Company to seek a different deal. Or they could have proposed a deal of their own. They could have declined to sign the Voting Agreement. And if they thought that Rich had extracted favorable terms, they could have participated in the Recapitalization as investors. Instead, they declined to invest with Rich and his group, signed the Voting Agreement, and let Rich and his group take the risk.
Fifth, the Funds agreed to the Covenant to induce Rich and his fellow investors to fund the Recapitalization. The Covenant affects Rich‘s ability to exit, and without it, he might not have led the Recapitalization or could have demanded different terms. Invalidating the Covenant changes the bargained-for exchange and shifts value to the Funds by permitting them to pursue rights that they gave up. After the Recapitalization, Rich, Rutchik, and Stella served on the Board and approved the Drag-Along Sale. Invalidating the Covenant changes their litigation exposure as well.
The facts of this case provide an example of sophisticated parties using a provision like the Covenant to allocate risk and order their affairs. This is a case where a provision like the Covenant can be enforced.
Although this decision upholds the Covenant against both facial and as-applied challenges, that does not mean that provisions of this sort will be upheld on different facts.294 Another powerful provision that Delaware courts review for reasonableness is a covenant not to compete. Parties can use covenants not to compete and other restrictive covenants to create value and facilitate commercial relationships. Yet sophisticated parties can also use restrictive covenants to take advantage of the less privileged. Humans are vulnerable to recurring psychological blind spots, including excessively discounting the future. Unless the party bargaining over a
A restrictive covenant affects an important economic right: the ability to work. A covenant not to sue affects a foundational civil right: the ability to access the courts. That right is foundational because it is necessary to protect all others. Without the ability to obtain a judgment from a court, backed by the power of the state, other rights become meaningless. Unless the holder of the right has some other source of leverage, like influence, economic power, or a willingness to deploy extra-legal force, then the counterparty can ignore the right. Without courts to enforce them, even voting rights can become nullities. In a civil society, what renders a right meaningful is access to the courts and, with a judgment in hand, the power of the state. A forward-looking covenant not to sue warrants greater scrutiny for reasonableness than a covenant not to compete precisely because it limits access to the courts.
A court only decides the case at hand.295 Nevertheless, it is easy to envision scenarios the proponent of a provision like the Covenant would face deep skepticism and a steep uphill slog. They could include:
- An agreement binding a retail stockholder.
- An employee stock grant.
- A dividend reinvestment plan.
- An employee stock compensation plan.
- A stock transmittal letter.
- A transaction that offered an election between base consideration and incremental consideration plus a covenant not to sue.296
There may well be other use cases for a provision like the Covenant, but they are likely to be few and limited to agreements between uber-sophisticated parties like the Rich Entities and the Funds.
H. A Public Policy Limitation From Contract Law
Although the Covenant is not invalid as a form of impermissible fiduciary tailoring, there is one remaining limitation on what the Covenant can accomplish. As a general matter, “[a] term exempting a party from tort liability for harm caused intentionally or recklessly is unenforceable on grounds of public policy.”297 Thus, “[a]n attempted exemption from liability for a future intentional tort . . . is generally held void . . . .”298 Delaware decisions addressing
‘damages,’ it will not protect a party from a claim involving its own fraud or bad faith.”299 A commercial agreement among sophisticated parties can only exonerate a party for liability for its own negligence.300
But as with many things in the law, the public policy line is blurred. There is one area where Delaware law has reached beyond the traditional limitations on contracting by providing a path for sophisticated parties to cabin liability for an intentional tort. In Abry Partners, Chief Justice Strine held while serving as a member of this court that sophisticated parties, bargaining at arm‘s length and with the ability to walk away freely, could enter into an acquisition agreement that expressly disclaimed reliance on any representations made outside of the agreement, thereby preventing those representations from supporting a fraud claim.301 The Chief Justice acknowledged that this outcome departed from the rule in the Restatement (Second) of Contracts and the law of other states, but he emphasized the importance that Delaware law places on the freedom of contract and “the ability of sophisticated businesses, such as the Buyer and Seller, to make their own
judgments about the risk they should bear and the due diligence they undertake, recognizing that such parties are able to price factors such as limits on liability.”302
Technically, the Abry Partners decision does not limit liability for fraud, but rather specifies the information on which a fraud claim can be based, which indirectly constrains liability for fraud. In substance, the party providing the anti-reliance representation covenants not to sue over any statements outside of the agreement. So viewed, Abry Partners authorizes a covenant not to sue that addresses an intentional tort. To date, Delaware decisions have declined to expand the Abry Partners principle beyond anti-reliance provisions, holding that other attempts to limit liability for fraud violate public policy.303 That trend suggests that Abry Partners should not be used to validate other provisions that seek to eliminate tort liability for intentional harm.
Recklessness is a different matter. As discussed previously,
A claim for breach of fiduciary duty is an equitable tort.306 To the extent the Covenant seeks to prevent the Funds from asserting a claim for an intentional breach of fiduciary duty, then the Covenant is invalid—not as an impermissible form of fiduciary tailoring, but because of policy limitations on contracting.
Otherwise, the Covenant bars challenges to the Drag-Along Sale. Thus, if the defendants engaged in self-interested transactions but believed in good faith that the transactions were not contrary to the best interests of the Company, then the Covenant forecloses those claims. The Covenant also forecloses claims that the defendants engaged in the self-interested transactions with reckless disregard for the best interests of the Company.
As discussed in the Pleading Decision, the Sale Counts could support liability for a bad faith breach of duty.307 Damages for that claim would result from an intentional tort. The Covenant therefore cannot bar the Sale Counts in their entirety.
III. CONCLUSION
The Covenant is not facially invalid as a prohibited form of fiduciary tailoring. The Covenant operates permissibly within the space for fiduciary tailoring that Delaware corporate law provides, particularly in a stockholder-level agreement that only addresses stockholder-level rights.
The Covenant is not unreasonable on the facts of this case. Sophisticated repeat players consented explicitly to a clear provision in a stockholder-level agreement that applies only to a specific transaction.
Nevertheless, the Covenant cannot relieve the defendants of tort liability for intentional harm. The Sale Counts could support that form of liability. The Covenant therefore does not foreclose the Sale Counts, and the defendants’ motion to dismiss those counts based on the Covenant is denied.
Notes
The Funds might have argued that the Covenant does not apply to self-dealing in the lead-up to a Drag-Along Sale. When the court raised the arguable mismatch at oral argument, the Funds picked up on it. Dkt. 34 at 26, 38. Because this decision declines to hold that the Covenant forecloses the Sale Counts, the Funds can explore this issue in discovery, and the parties can address it later should it prove salient.
A person acts with criminal negligence with respect to an element of an offense when the person fails to perceive a risk that the element exists or will result from the conduct. The risk must be of such a nature and degree that failure to perceive it constitutes a gross deviation from the standard of conduct that a reasonable person would observe in the situation.
Senate Bill 363, 72 Del. Laws 619 (2000).categories of business opportunities may be specified by any manner of defining or delineating business opportunities or the corporation‘s or any other party‘s entitlement thereto or interest therein, including, without limitation, by line or type of business, identity of the originator of the business opportunity, identity of the party or parties to or having an interest in the business opportunity, identity of the recipient of the business opportunity, periods of time or geographical location.
Id. at 243. Section 253 is thus another example of a DGCL provision that limits loyalty claims.By enacting a statute [
8 Del. C. § 253 ] that authorizes the elimination of the minority without notice, vote, or other traditional indicia of procedural fairness, the General Assembly effectively circumscribed the parent corporation‘s obligations to the minority in a short-form merger. The parent corporation does not have to establish entire fairness, and, absent fraud or illegality, the only recourse for a minority stockholder who is dissatisfied with the merger consideration is appraisal.
Client consent to conflicts that might arise in the future is subject to special scrutiny, particularly if the consent is general. A client‘s open-ended agreement to consent to all conflicts normally should be ineffective unless the client possesses sophistication in the matter in question and has had the opportunity to receive independent legal advice about the consent. . . . On the other hand, particularly in a continuing client-lawyer relationship in which the lawyer is expected to act on behalf of the client without a new engagement for each matter, the gains to both lawyer and client from a system of advance consent to defined future conflicts might be substantial. A client might, for example, give informed consent in advance to types of conflicts that are familiar to the client. Such an agreement could effectively protect the client‘s interest while assuring that the lawyer did not undertake a potentially disqualifying representation.Id. cmt. d.