WEST PALM BEACH FIREFIGHTERS’ PENSION FUND, on behalf of itself and all other similarly-situated Class A stockholders of MOELIS & COMPANY v. MOELIS & COMPANY
C.A. No. 2023-0309-JTL
IN THE COURT OF CHANCERY OF THE STATE OF DELAWARE
February 23, 2024
OPINION ADDRESSING THE VALIDITY OF PROVISIONS IN A STOCKHOLDER AGREEMENT
Date Submitted: October 18, 2023
Date Decided: February 23, 2024
Thomas Curry, Taylor D. Bolton,
John P. DiTomo, Miranda N. Gilbert, MORRIS, NICHOLS, ARSHT & TUNNELL LLP, Wilmington, Delaware; William Savitt, Anitha Reddy, Getzel Berger, Emma S. Stein, WACHTELL, LIPTON, ROSEN & KATZ, New York, New York; Counsel for Defendant.
LASTER, V.C.
What happens when the seemingly irresistible force of market practice meets the traditionally immovable object of statutory law? A court must uphold the law, so the statute prevails.
The immovable statutory object is
- “A cardinal precept of the General Corporation Law of the State of Delaware is that directors, rather than shareholders, manage the business and affairs of the corporation.”2
- “The bedrock of the General Corporation Law of the State of Delaware is the rule that the business and affairs of a corporation are managed by and under the direction of its board.”3
- “The board has a large reservoir of authority upon which to draw. Its duties and responsibilities proceed from the inherent powers conferred by
8 Del. C. § 141(a) .”4 - “The ultimate responsibility for managing the business and affairs of a corporation falls on its board of directors.”5
- “The General Corporation Law of the State of Delaware . . . and the decisions of this Court have repeatedly recognized the fundamental principle that the management of the business and affairs of a Delaware corporation is entrusted to its directors, who are the duly elected and
authorized representatives of the stockholders.”6 - “One of the most basic tenets of Delaware corporate law is that the board of directors has the ultimate responsibility for managing the business and affairs of a corporation. . . .
Section 141(a) . . . confers upon any newly elected board of directors full power to manage and direct the business and affairs of a Delaware corporation.”7
The presence of a stockholder who controls the corporation does not alter the board-centric framework. “[D]irector primacy remains the centerpiece of Delaware law, even when a controlling stockholder is present.”8
Internal corporate governance arrangements that do not appear in the charter and deprive boards of a significant portion of their authority contravene
Crashing into this traditionally immovable object is the seemingly irresistible force of market practice. Corporate planners now regularly implement internal governance arrangements through stockholder agreements. The new wave of stockholder agreements does not involve stockholders contracting among themselves to address how they will exercise their stockholder-level rights. The new-wave agreements contain extensive veto rights and other restrictions on corporate action.10
The plaintiff challenges one such governance arrangement. Moelis & Company (the “Company“) is a global investment bank. Ken Moelis is its eponymous founder, CEO, and Chairman of the Board. After years of success operating the investment bank as a private entity, Moelis decided to raise capital from the public markets. He created the Company as a new holding company and reorganized the bank‘s underlying entity structure. One day before the Company‘s
The Stockholder Agreement is a new-wave agreement. Under its terms, the Company‘s board of directors (the “Board“) must obtain Moelis’ prior written consent before taking eighteen different categories of action (the “Pre-Approval Requirements“). The Pre-Approval Requirements encompass virtually everything the Board can do. Because of the Pre-Approval Requirements, the Board can only act if Moelis signs off in advance.
Another set of provisions compels the Board to ensure that Moelis can select a majority of its members (collectively, the “Board Composition Provisions“). The Board is contractually obligated to maintain its size at not more than eleven seats (the “Size Requirement“). Moelis is entitled to name a number of designees equal to a majority of those seats (the “Designation Right“). The Board must nominate Moelis’ designees as candidates for election (the “Nomination Requirement“). The Board must recommend that stockholders vote in favor of Moelis’ designees (the “Recommendation Requirement“). The Company must use reasonable efforts to enable Moelis’ designees to be elected and continue to serve (the “Efforts Requirement“). And the Board must fill any vacancy in a seat occupied by a Moelis designee with a new Moelis designee (the “Vacancy Requirement“). Even if Moelis holds less than a majority of the Company‘s outstanding voting power, as is currently true, the Board Composition Provisions force the directors to ensure that his designees control the Board.
A final provision in the Stockholder Agreement forces the Board to populate any committee with a number of Moelis’ designees proportionate to the number of designees on the full Board (the “Committee Composition Provision“). Because of the Committee Composition Provision, the Board cannot create a committee with a different number of Moelis designees unless Moelis consents. The Board cannot create an independent committee without any Moelis designees unless Moelis consents.
The plaintiff is a Company stockholder who contends that the Pre-Approval Requirements, the Board Composition Provisions, and the Committee Composition Provision (collectively, the “Challenged Provisions“) violate
The plaintiff and the Company have filed cross motions for summary judgment.11 The plaintiff advances a straightforward argument. Under Chancellor Seitz‘s seminal decision in Abercrombie v. Davies, governance restrictions violate
or “tend[] to limit in a substantial way the freedom of director decisions on matters of management policy . . . .”12 The Delaware Supreme Court has repeatedly endorsed
The plaintiff says the Challenged Provisions fail that test. The Pre-Approval Requirements mean that Moelis determines what action the Board can take. The directors cannot exercise their own judgment. They must check with Moelis first and can only proceed with his approval. The Board Composition Provisions prevent the directors from using their best judgment when recommending candidates, filling vacancies, and determining the size of the Board. Instead, the directors must keep Moelis in control at the Board-level. And the Committee Composition Provision prevents the directors from exercising discretion when creating committees. Every committee must have the same proportionate number of Moelis’ designees as the full Board.
The Company offers a one-size-fits-all response: A contract is a contract is a contract. Delaware corporations possess the power to contract, and contracts necessarily constrain a board‘s freedom of action. A corporation that has agreed to an exclusive supply contract cannot freely contract with a different supplier. No one would suggest that an exclusive supply contract violates
The Company jumps to the conclusion that a court cannot differentiate between an internal governance arrangement and an external commercial contract. Because differentiation is impossible, either all contracts fail under
That is a version of the soritical paradox, which draws no distinction between a
Framed in soritical terms, any external commercial contract limits a board to the same degree as a heap of internal governance constraints. Because there is nowhere to draw the line,
The soritical paradox bedevils logicians, but not mere humans. We can recognize prototypes and draw distinctions by comparing and contrasting an example with a prototype. A housecat and a lion both have paws, claws, and other feline features. Yet for us, one is a pet and the other a predator. Show me a bobcat or a lynx, and I will keep a respectful distance. Yes, there can be close cases (is a love seat more like a couch or a chair?), but if anyone can make these types of distinctions, courts can. Cases regularly turn on whether the facts are more like one precedent or another. That‘s how legal reasoning works.
The Challenged Provisions look like something a law professor dreamed up for students to use as a prototypical
The Challenged Provisions are therefore part of an internal governance arrangement. That makes them subject to
The plaintiff challenges the Pre-Approval Requirements individually and collectively. This decision only reaches the collective challenge. Taken together, the Pre-Approval Requirements force the Board to obtain Moelis’ prior written consent before taking virtually any meaningful action. With the Pre-Approval Requirements in place, the Board is not really a board. The directors only manage the Company to the extent Moelis gives them permission to do so. This decision need not consider whether some lesser combination of rights might рass muster under
The Company responds that the Pre-Approval Requirements do not prevent the Board from exercising its powers because Moelis only has veto rights. That is not true. Moelis has pre-approval rights. The Board cannot approve, authorize, or even plan to take a covered action without Moelis’
In any event, rewriting the Pre-Approval Requirements as vetoes would not change anything. If framed as eighteen vetoes, the provisions still would give Moelis the ability to block virtually anything the Board might do. The Board would be in the same position as a management team who propose options for a board to review and approve. With Moelis holding the eighteen vetoes, the Board would propose options for Moelis to review and approve. “[T]he power to review is the power to decide.”15 Here, Moelis has expansive power to review, which gives him the power to decide.
Because of the Pre-Approval Requirements, the business and affairs of the Company are managed under the direction of Moelis, not the Board. The Pre-Approval Requirements therefore violate
Three of the Board Composition Provisions violate
The Committee Composition Provision violates both
The Company argues that the plaintiff‘s facial challenge fails nevertheless because these provisions can operate validly as long as Moelis and the Board agree. But when Moelis and the Board agree, the provisions are not operating at all. Directors can freely decide to follow the advice of the corporation‘s CEO and Chairman. That is different from being prevented from acting by a contractual provision. The Challenged Provisions only have bite when the Board wants to take action and Moelis disagrees. There is no setting where Moelis could invoke the provisions without triggering a
Three of the Board Composition Provisions do not facially violate
The Nomination Requirement is also not facially invalid. Moelis could nominate his
The Company likewise can agree through the Efforts Requirement to facilitate the election and continued service of Moelis’ designees. Legitimate efforts could involve including their names on a proxy card or providing disclosures about them in its proxy statement.
There could be as-applied challenges to the Designation Right, Nomination Requirement, and Efforts Requirement, but not a facial challenge.
Moelis did not have to frame an internal cоrporate governance arrangement using the Stockholder Agreement. He could have accomplished the vast majority of what he wanted through the Company‘s certificate of incorporation (the “Charter“).16 Even now, the Board could implement many of the Challenged Provisions by using its blank check authority to issue Moelis preferred stock carrying a set of voting rights
and director appointment rights.17 A new class of preferred stock need not upset the Company‘s equity allocation; it could consist of a single golden share. The certificate of designations for the new preferred stock would become part of the Charter as a matter of law.18 At that point, because the provisions would appear in the Charter, they would comply with
I. FACTUAL BACKGROUND
The parties filed cross-motions for summary judgment. When there are factual disputes, ruling on cross-motions for summary judgment can be difficult because the court must construe the record in favor of one non-movant for one motion and the other for the other motion.22 Here, the competing standards are not a problem, because the pertinent facts are undisputed.23
A. The Company And Its IPO
In 2007, Moelis formed a new boutique investment bank. He ran the business as CEO and Chairman of the Board. The bank enjoyed immediate success and expanded globally. By 2013, it was generating over $400 million in annual revenue.
In 2014, Moelis decided to raise capital by selling shares to the public. Before the IPO, he transferred the bank‘s business to a newly formed Delaware limited partnership named Moelis & Company Group LP (the “Group“). The Group issued general partner units and Class A limited partnership units.
Moelis formed the Company to be the new publicly traded entity. The Company owns all of the member interests in an LLC that serves as the general partner of
Moelis allocated the other 73% of the Class A units to Moelis & Company Partner Holdings LP (“Holdings“). Moelis and other bankers and employees own the equity in Holdings. Moelis controls Holdings.
The Company has two authorized classes of common stock. In its IPO, the Company issued shares of its Class A common stock to the public, and those shares trade on the New York Stock Exchange. The Class A shares carry one vote per share.
Only Holdings received Class B common stock. The Class B shares carry ten votes per share as long as Moelis
- maintains directly or indirectly ownership of an aggregate of at least 4,458,445 shares of Class A Common Stock . . . .;
- maintains directly or indirectly beneficial ownership of at least five percent (5%) of the issued and outstanding Class A Common Stock [and Class A units issued by the Group, which are convertible into Class A shares];
- has not been convicted of a criminal violation of a material U.S. federal or state securities law that constitutes a felony or a felony involving moral turpitude;
- is not deceased; and
- has not had his employment agreement terminated . . . because of a breach of his covenant to devote his primary business time and effort to the business and affairs of the [Company] or because he suffered an Incapacity.24
That set of conditions is known as the “Class B Condition.”25
B. The Stockholder Agreement
In the prospectus for the IPO, the Company disclosed that Moelis and the Company would enter into the Stockholder Agreement. On April 15, 2014, one day before the Class A shares began trading, the Company, Moelis, Holdings, and two other Moelis affiliates executed the Stockholder Agreement.26 No one disputes that investors who purchased stock in the IPO had notice of the Stockholder Agreement.
The Stockholder Agreement remains in effect as long as a modified version of the Class B Condition is satisfied. Known as the “Secondary Class B Condition,” the requirements are the same as the Class B Condition, except that the specific ownership rеquirement for shares of Class A stock or instruments convertible into Class A shares drops from 4,458,445 to 2,229,222.27 If the Secondary Class B Condition fails, then the Stockholder Agreement terminates.28
The Stockholder Agreement grants Moelis expansive rights. Technically, the Stockholder Agreement allocates many of the rights to Holdings, but because Moelis
1. The Pre-Approval Requirements
The Stockholder Agreement contains the Pre-Approval Requirements. The pertinent language states:
So long as the Class B Condition is satisfied, the Board shall not authorize, approve or ratify any of the following actions or any plan with respect thereto without the prior approval (which approval may be in the form of an action by written consent) of [Moelis]:
(i) any incurrence of indebtedness (other than inter-company indebtedness), in one transaction or a series of related transactions, by the Company or any of its Subsidiaries or Controlled Affiliates in an amount in excess of $20 million;
(ii) any issuance by the Company or any of its Subsidiaries or Controlled Affiliates in any transaction or series of related transactions of equity or equity-related securities (other than preferred stock, which is addressed by Section 2.1(a)(iii) below) which would represent, after such issuance, or upon conversion, exchange or exercise, as the case may be, at least three percent (3%) of the total number of votes that may be cast in the election of directors of the Company if all issued and outstanding Class A Shares were present and voted at a meeting held for such purpose . . . ;
(iii) the issuance of any preferred stock;
(iv) any equity or debt commitment to invest or investment or series of related equity or debt commitments to invest or investments by the Company . . . in an amount greater than $20 million;
(v) any entry by the Company or any of its Subsidiaries or Controlled Affiliates into a new line of business that requires an investment in excess of $20 million;
(vi) the adoption of a stockholder rights plan by the Company;
(vii) any removal or appointment of any officer of the Company that is, or would be, subject to Section 16 of the Exchange Act;
(viii) any amendment to the Certificate of Incorporation or By-Laws;
(ix) any amendment to the Partnership LP Agreement;
(x) the renaming of the Company;
(xi) the adoption of the Company‘s annual budget and business plans and any material amendments thereto;
(xii) the declaration and payment of any dividend or other distribution (other than such dividends or other distributions (i) required to be made pursuant to the terms of any outstanding preferred stock of the Company or (ii) in connection with the transactions described in the IPO Registration Statement);
(xiii) the entry into any merger, consolidation, recapitalization, liquidation, or sale of the Company or all or substantially all of the assets of the Company or consummation of a similar transaction involving the Company . . . ;
(xiv) voluntarily initiating any liquidation, dissolution or winding up of the Company or permitting the commencement of a proceeding for bankruptcy, insolvency, receivership or similar action with respect to the Company or any of its Subsidiaries or Controlled Affiliates;
(xv) the entry into or material amendment of any Material Contract;
(xvi) the entry into any transaction, or series of similar transactions or Contract . . . that would be required to be disclosed under Item 404 of Regulation S-K under the Exchange Act; (xvii) the initiation or settlement of any material Action; or
(xviii) changes to the Company‘s taxable year or fiscal year.29
Viewed in their totality, the Pre-Approval Requirements mean that the Board must get Moelis’ signoff in advance for virtually any action the directors might want to take.30
2. The Board Composition Provisions
As long as the Class B Condition is satisfied, the Board Composition Provisions give Moelis the right to determine the size of the Board and select a majority of the directors who serve on it. There are six Board Composition Provisions: the Size Requirement, the Designation Right, the Nomination Requirement, the Recommendation Requirement, the Efforts Requirement, and the Vacancy Requirement.
Section 4.1(a) of the Stockholder Agreement allows Moelis to select a number of designees currently equal to a majority of the Board. It states:
Until the Class B Condition ceases to be satisfied, the Company and each Stockholder shall take all reasonable actions within their respective control (including voting or causing to be voted all of the Voting Securities held of record by such Stockholder or Beneficially Owned by such Stockholder by virtue of having voting power over such Voting Securities, and, with respect to the Company, as provided in Sections 4.1(c) and (d) ) [sic] so as to cause to be elected to the Board, and to cause to continue in office,
[1] not more than eleven (11) directors (or such other number of directors as [Moelis] may agree to in writing),
[2] and at any given time:
(i) until the Class B Condition ceases to be satisfied, a number of directors equal to a majority of the Board shall be individuals designated by [Moelis]; and
(ii) after the Class B Condition ceases to be satisfied, for so long as the Secondary Class B Condition is satisfied, a number of directors (rounded up to the nearest whole number) equal to one quarter of the Board shall be individuals designated by [Moelis].31
That language includes the Size Requirement, which requires that the Company use its best efforts to maintain a Board of not more than eleven directors. It includes
Section 4.1(c) of the Stockholder Agreement contains two more Board Composition Provisions. It states:
The Company agrees to include in the slate of nominees recommended by the Board those persons designated by [Moelis] in accordance with Section 4.1(a) and to use its reasonable best efforts to cause the election of each such designee to the Board, including nominating such designees to be elected as directors, in each case subject to applicable law.32
This provision contains the Nomination Requirement, under which the Company must nominate Moelis’ designees for election as directors. It also contains the Recommendation Requirement, under which the Board must recommend in favor of Moelis’ designees, whoever they might be. And it includes the second part of the Efforts Provision, which requires that the Company “use its reasonable best efforts to cause the election of such designees to the Board.”
Finally, Section 4.1(d) of the Stockholder Agreement contains the Vacancy Requirement. It states:
In the event that a vacancy is created at any time by the death, disability, retirement, resignation or removal of any director who is designated by [Moelis] in accordance with Section 4.1(a), the Company agrees to take at any time and from time to time all actions necessary to cause the vacancy created thereby to be filled as promptly as practicable by a new designee of [Moelis].33
Under this provision, Moelis can require that the Company replace any of his designees who leave the Board with a new designee.
3. The Committee Composition Provision
As long as the Stockholder Agreement remains in effect, the Committee Composition Provision gives Moelis the right to have a proportionate number of his designees serve on any board committee. The pertinent language states:
For so long as this Agreement is in effect, the Company shall take all reasonable actions within its control at any given time so as to cause to be appointed to any committee of the Board a number of directors designated by [Moelis] that is up to the number of directors that is proportionate (rounding up to the next whole director) to the representation that [Moelis] is entitled to designate to the Board under this Agreement, to the extent such directors are permitted to serve on such committees under the applicable rules of the SEC and the New York Stock Exchange or by any other applicable stock exchange.34
Currently, Moelis has the right to designate a majority of the Board, so the Committee Composition Provision requires that every committee have a majority of Moelis designees. Without Moelis’ consent, the Board cannot create a committee with a lesser number of Moelis designees. The
C. Moelis’ Ownership Declines After The IPO.
After the IPO, Moelis controlled 96.8% of the Company’s outstanding voting power. Since the IPO, Moelis has sold off stock, and his voting power has declined. In February 2021, his voting power fell below 50%, causing the Company to no longer qualify as a controlled company under New York Stock Exchange rules. The Company changed the membership of its Board and committees to comply with the rules for non-controlled companies. Moelis is still entitled to designate a majority of the Board, but he waived that right in 2021, 2022, and 2023 to ensure compliance with the rules for non-controlled companies.
Presently, Moelis owns approximately 6.5% of the outstanding equity and possesses the right to obtain additional shares that would bring his equity interest to 11.5%. The Class B Condition therefore continues to be satisfied. Because Moelis continues to beneficially own all the Company’s Class B stock, his voting power currently stands at 40.4%.
D. This Litigation
The plaintiff is an owner of Class A stock. He purchased his shares on November 19, 2014. He filed this action on March 13, 2023. The plaintiff seeks declarations that the Challenged Provisions are invalid and unenforceable. The Company answered the complaint, and the parties filed cross-motions for summary judgment.
II. LEGAL ANALYSIS
Under
This decision starts by framing the elements of a Section 141(a) claim. That statute presents a puzzle, because its plain language prohibits restrictions on board authority that do not appear in the DGCL or the corporate charter. Every contract restricts board authority to some degree, so how does a court distinguish contractual provisions that violate Section 141(a) from those that do not?
To answer that question, this decision surveys the Section 141(a) precedents. That effort is tedious but fruitful, because it reveals a clear rule. Although none of the cases say so expressly, they show that a court applying Section 141(a) must first determine whether the challenged provision constitutes part of the corporation’s internal governance arrangement. If not, then the inquiry ends. If so, then Section 141(a) applies.
This decision concludes that the Challenged Provisions are part of the Company’s internal governance arrangement. Not only that, but the Stockholder Agreement in general and the Challenged Provisions in particular offer a prototype for what a governance arrangement looks like.
Once Section 141(a) applies, the court applies the Abercrombie test. The plaintiff attacks the Pre-Approval Requirements both individually and in the aggregate. This decision only considers them in the aggregate. Taken together, the Pre-Approval Requirements are facially invalid
The decision wraps up by considering the Company’s policy arguments.
A. The Elements Of A Section 141(a) Claim
The plaintiff contends that the Challenged Provisions violate Section 141(a) of the DGCL. To reiterate, that section 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.”35 To succeed on a facial challenge, the plaintiff must show that the Challenged Provisions cannot operate lawfully in the face of Section 141(a) “under any circumstances.”36
An extensive body of Delaware precedent analyzes Section 141(a) claims.37 Many decisions have invalidated express limitations on board authority when they did not appear in the charter and restricted a significant board function. Others have considered Section 141(a) claims and acknowledged their doctrinal legitimacy,
Delaware decisions regularly recognize that ordinary commercial contracts do not raise Section 141(a) concerns. One way to avoid implicating commercial contracts would be to interpret the requirement that restrictions on board authority appear only in the DGCL or the charter as a “bylaw excluder”; it tells corporate planners that provisions in the bylaws cannot restrict the board’s power, but says nothing more than that.39 But that interpretation cannot coexist with the weight of Section 141(a) precedent. As discussed below, Section 141(a) decisions have rendered invalid provisions in stockholder agreements, agreements among directors, rights plans, stock purchase agreements, asset sale agreements, and merger agreements. Under extant case law, the mere fact that a provision appears in a contract and not in the bylaws does not create a safe harbor from Section 141(a) challenge.
What has proved elusive is some method of distinguishing invalid restrictions on board authority from valid exercises in contracting. But a careful review of the Section 141(a) canon reveals a clear rule. Although none of the Section 141(a) cases say so expressly, the decisions distinguish between external commercial agreements and provisions that seek to govern the corporation’s internal affairs. All of the successful Section 141(a) challenges have involved contracts or provisions tied to a corporation’s internal affairs. The most controversial decisions have involved challenges to provisions in merger agreements where an internal affairs dimension of the merger agreement overlapped with the contract rights of a third-party buyer. There are no Section 141(a) decisions that invalidate or even raise serious questions about provisions in commercial agreements.
The decisions also show the types of restrictions that can violate Section 141(a). The cases consistently invalidate provisions that purport to bind the board or individual directors explicitly. This decision refers to those as direct, board-level restrictions.
A direct, board-level restriction targets the board itself or a director. But if Section 141(a) only applied to those restrictions, then corporate planners could circumvent the statute by specifying that a provision imposed an obligation on the corporation. The Section 141(a) decisions show that a provision can be invalid if requires or forbids action on an issue that falls exclusively within the board’s authority. A provision also can be invalid if it calls for an actor other than the board to make a determination or perform a task where the DGCL or the common law requires board action. This decision refers to those as direct, corporate-level restrictions.
Restrictions can also operate indirectly by imposing consequences for particular action. In Abercrombie, the agreement called for the signatory stockholders to immediately remove any director who did not vote in accordance with the outcome from a dispute-resolutiоn mechanism. Chancellor Seitz held that immediate removal was a sufficiently powerful
That taxonomy generates the following matrix:
| Direct | Indirect | |
| Board-level | Purports to bind the board or individual directors, as in “the board shall” or “the board shall not.” | Imposes a sufficiently onerous consequence on the board or individual directors for taking or not taking the specified action. |
| Corporate-level | Purports to bind the company, as in “the company shall” or “the company shall not,” where the issue requires a board decision. | Imposes a sufficiently onerous consequence on the company for taking or not taking an action that requires a board decision. |
1. The Decisions
The Section 141(a) decisions can be grouped into seven categories. Six of the categories involve multiple decisions. They are:
- Cases involving stockholder or director agreements;
- Cases involving rights plans;
- Cases involving CEO employment agreements;
- Cases involving improper delegations of board power;
- Cases involving the termination of merger agreements; and
- Cases involving bylaws.
The seventh category includes just one case—Sample. That is the only case that proposes rejecting the Section 141(a) inquiry entirely.
a. Stockholder And Director Agreements: Abercrombie, Marmon, Schroeder, and Chapin
The first category includes four cases. Abercrombie, Marmon,40 and Schroeder41 involved stockholder agreements. Chapin involved a director agreement. The cases showcase the invalidity of direct and indirect board-level restrictions.
i. Abercrombie
The cornerstone of the contemporary Section 141(a) canon is Abercrombie.42 The
Three years later, six of the stockholders entered into a second stockholder agreement, which they called the “agents agreement.”45 Those six stockholders had the right to designate eight directors, comprising a board majority.46
The purpose of the agents agreement was to ensure that the eight directors voted as a block. To that end, the stockholders agreed to appoint their eight designees as agents who would attempt to reach consensus on how they would vote as directors (the “Voting Provision”). If seven out of eight agents agreed, then all would vote that way.47 If seven could not agree, then an arbitrator would determine how they would vote.48 The operative language stated:
The Shareholders further agree that Ralph K. Davies shall vote, and that the corporate Shareholders will use their best efforts to cause their representatives on the Board of Directors . . . to vote . . . as determined by the Agents or by any seven thereof, and that in the event of the failure of any such director so to vote all parties hereto will cooperate and act in any legal manner possible to cause any director voting contrary to any such determination by the Agents to resign or be removed and to be replaced upon the Board of Directors . . . . In the event of any failure of any seven of the directors representing the Shareholders so to agree, the dispute, wherever possible to do so, shall be settled by submission to an arbitrator or arbitrators appointed in the same manner as in the case of a disagreement between the Agents.49
Davies was both a stockholder and a director, so he bound himself to vote as a director in accordance with the Voting Provision.50 The other five stockholders were corporations who designated individuals as directors.51 They agreed to “use
Chancellor Seitz held that the Voting Provision violated Section 141(a). He explained that “our corporation law does not permit actions or agreements by stockholders which would take all power from the board to handle matters of substantial management policy.”54 For Davies, the Voting Provision was “clearly illegal” because he bound himself to vote as a director in the manner determined by the agents or an arbitrator.55 It operated as a direct, board-level restriction, which violated Section 141(a).
For the other directors, the issue was more complex. They did not technically bind themselves to vote as determined by someone else, but the stockholders were bound to remove any non-compliant director. Chancellor Seitz determined that this mechanism imposed was also invalid:
Because it tends to limit in a substantial way the freedom of director decisions on matters of management policy it violates the duty of each director to exercise his own best judgment on matters coming before the board. Moreover, a director-agent might here feel bound to honor a decision rendered under the Agreement even though it was contrary to his own best judgment.56
The provision operated as an indirect, board-level restriction that was functionally equivalent to a direct, board-level restriction.
Chancellor Seitz concluded: “So long as the corporate form is used as presently provided by our statutes this Court cannot give legal sanction to agreements which have the effect of removing from directors in a very substantial way their duty to use their own best judgment on management matters.”57 The Voting Provision was “invalid as an unlawful attempt by certain stockholders to encroach upon the statutory powers and duties imposed on directors by the Delaware corporation law.”58
The Abercrombie decision offers three powerful lessons. First, a provision in a stockholder agreement can violate Section 141(a). Second, a direct board-level restriction is invalid, as shown by the ruling about how the Voting Provision applied to Davies. Third, an indirect board-level restriction is also invalid, as shown by the ruling about how the Voting Provision applied to the other directors.
ii. Marmon and Schroeder
Two later cases also dealt with stockholder agreements. In Marmon, Justice Jacobs was sitting by designation after
That response, if truthful, is difficult to characterize in neutral terms. The directors of a Delaware corporation have a duty to disclose material facts to all of the corporation’s shareholders. The directors are not free arbitrarily to pick and choose the shareholders to whom they will or will not make disclosure. Nor can the corporation be heard to defend such a practice on the basis that it has bound itself contractually not to make such disclosures. Arbinet’s directors were not free to contract away disclosure obligations that they had a fiduciary duty to observe.62
The stockholder agreements could not limit the board’s powers under Section 141(a) and its concomitant obligations to disclose information to stockholders. It is not clear whether the disclosure restrictions were drafted as direct, board-level restrictions or as direct, corporate-level restrictions. Either way, the provisions were invalid.
In Schroeder, stockholders bound themselves to elect (i) three directors 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.63 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.64
The court resolved the interpretative question by considering the implications of Section 141(a). The decision held that appointing a CEO is a core board functiоn and noted that the company’s bylaws called for the board to select the CEO.65 If the stockholder agreement enabled the common stockholders to select the CEO, then the provision would be invalid because it would conflict with Section 141(a) and the bylaws.66 But if the board had the power to identify the CEO, at which point the common stockholders had to name him as one of their three designees, then the stockholder agreement would operate consistently with Section 141(a) and the bylaws. The court adopted the latter interpretation as the only reasonable one and
Like Abercrombie, the rulings in Marmon and Schroeder show that provisions in stockholder agreements can violate Section 141(a). They also show that a provision need not deprive a board of virtually all of its powers, like the agents agreement in Abercrombie, to give rise to a statutory issue. The agreements in Marmon only restricted disclosure, and the agreement in Schroeder only governed the selection of the CEO. Both created problems under Section 141(a).
iii. Chapin
The Chapin case involved an agreement among directors.68 The entity was a Delaware nonstock corporation, and its directors (called trustees) comprised its members by virtue of being trustees. When the corporation was formed in 1944, there were three trustees. By 1946, the trustees had added a fourth. In 1952, the four trustees “became concerned about the balance between them being upset by the death of one of their number,” so they entered into an agreement that specified in advance who would succeed each trustee.69 The charter empowered the trustees in office to fill any vacancies, without limitation.70
Over the next twenty years, each new combination of trustees entered into a similar agreement.71 In the last iteration, executed in 1972, the trustees also bound themselves and their successors to maintain a board of four, and they agreed that any board action would be invalid unless the board had four members. The charter, by contrast, authorized a board of as few as three and as many as five.72
In 1976, three of the trustees voted to rescind the 1972 agreement. The fourth did not vote and died two months later. The three trustees did not replace him until 1977, when they increased the number of trustees to five.73
Shortly thereafter, the trustees became concerned about the validity of the actions they had taken since voting to rescind the 1972 agreement. The trustees sought a declaration that the agreement could not have been binding because it violated Section 141(a).74
Chancellor Brown, then serving as a Vice Chancellor, appointed an amicus curiae to oppose the petition.75 The amicus argued that because the trustees were also members of the non-stock corporation, the 1972 agreement operated as a valid stockholder agreement. Vice Chancellor Brown disagreed: “A stockholder has an ownership interest in his shares. To the extent that he contracts away the rights deriving from that interest, it is his prerogative to do so.”76 The trustees were only members because of their status as trustees. That meant they had “no personal ownership interest in the [corporation] to be used as a basis for their executing a voting agreement as stockholders.” For them to bind themselves in advance was an invalid restriction on their board-level authority.
ownership rights which they can contract away.”77 They only had their obligations as trustees, “and the contractual attempt to relinquish
The amicus next argued that by entering into the 1972 agreement, the trustees had not prevented themselves from exercising their judgment as trustees.79 Instead, they had exercised that authority by agreeing on what the size of the board should be and who should replace them. Vice Chancellor Brown rejected that argument as well. Citing Abercrombie and other precedents, he relied on “the longstanding rule that directors of a Delaware corporation may not delegate to others those duties which lay at the heart of the management of the corporation.”80 He invalidated both the size restriction and the agreement regarding the filling of vacancies.81
Like Abercrombie‘s ruling about Davies, Chapin shows that direct, board-level restrictions are invalid. Like Marmon and Schroeder, Chapin shows that a restriction need not extend to all of a board‘s activities to violate
Chapin is also significant for another reason. It did not involve a stockholder invoking
b. Rights Plans: Toll Brothers, Quickturn II, and UniSuper
The next group of cases involved stockholder rights plans. In Toll Brothers, then-Vice Chancellor Jacobs considered a provision that prevented particular directors from redeeming the rights.82 In Quickturn II, the Delaware Supreme Court considered a provision that delayed the ability of directors to redeem the rights.83 In UniSuper, Chancellor Chandler considered whether a board bind itself to condition the extension of a rights plan beyond one year on stockholder approval.84
The Toll Brothers decision concerned a “dead hand” feature, which meant that only the incumbent directors who adopted the rights plan (or their hand-picked successors) could redeem it.85 The plaintiff asserted the dead-hand feature violated
Similar issues arose in Quickturn II, where a board defended against a hostile bid by adopting a rights plan that contained a delayed redemption provision.88 That feature prevented any newly elected board from redeeming the rights for six months to facilitate a transaction with the hostile bidder.89 Vice Chancellor Jacobs enjoined the deferred redemption provision on equitable grounds.90 On appeal, the Delaware Supreme Court held that the deferred redemption provision was invalid under
Section 141(a) requires that any limitation on the board‘s authority be set out in the certificate of incorporation. The Quickturn certificate of incorporation contains no provision purporting to limit the authority of the board in any way. The Delayed Redemption Provision, however, would prevent a newly elected board of directors from completely discharging its fundamental management duties to the corporation and its stockholders for six months. While the Delayed Redemption Provision limits the board of directors’ authority in only one respect, the suspension of the Rights Plan, it nonetheless restricts the board‘s power in an area of fundamental importance to the shareholders—negotiating a possible sale of the corporation.92
The high court stressed that “to the extent that a contract, or a provision thereof, purports to require a board to act or not act in such a fashion as to limit the exercise of fiduciary duties, it is invalid and unenforceable.”93 The delayed redemption provision failed that test because it “tend[ed] to limit in a substantial way the freedom of newly elected directors’ decisions on matters of management policy.”94
In UniSuper, after an Australian corporation proposed to reincorporate to Delaware, several major stockholders expressed concern about the board‘s ability to adopt a rights plan.95 To mollify them, the board resolved that without stockholder approval, the directors would not adopt a rights plan with a duration longer than one year or renew a rights plan beyond
When stockholders sued to enforce the policy, the defendants argued that the policy could not constrаin the board‘s authority under
The rights plan decisions confirm that a direct, board-level restriction will not survive simply because it appears in a third-party agreement. Technically, a rights agreement is a contract with a rights agent. In substance, however, it is a control device and functionally part of the entity-specific governance arrangement. The rights plan decisions also show yet again that a provision need not constrain a board entirely to give rise to a
The UniSuper decision reinforces the lesson of Chapin. Although stockholders may rely on
c. CEO Employment Agreements: Grimes and Politan
The next two decisions involved employment agreements with CEOs. In both, the plaintiffs contended that the financial consequences of terminating the CEO were so great as to deprive the board of its ability to manage the corporation under
The CEO‘s employment agreement in Grimes provided that if he determined in good faith that the board of directors had “unreasonably interfered with his management of the corporation,” then he could declare his employment terminated and collect benefits totaling up to $20 million (the “No-Interference Condition“).106 A stockholder plaintiff challenged the employment agreement, contending that the No-Interference Condition constituted an abdication of the board‘s authority and the CEO‘s severance was so large that the board could not terminate him.107
Chancellor Allen recognized that a board “may not either formally or effectively abdicate its statutory power and its fiduciary duty to manage or direct the management of the business and affairs of this corporation.”108 He held that the No-Interference Provision did not formally restrict the board.109 Although it was “unusual,” “troubling,” and “ill-conceived,” he equated it with a poorly worded condition precedent for a CEO to declare a constructive termination.110
Chancellor Allen then considered whether the contractual consequences of termination were so great that the “practical effect” imposed an impermissible constraint.111 After assuming it was possible, Chancellor Allen held that the plaintiff had not pled sufficient facts to state a claim
The high court affirmed. The justices quoted the Abercrombie test with approval,113 while stressing that ordinary commercial contracts do not violate
[B]usiness decisions are not an abdication of directorial authority merely because they limit a board‘s freedom of future action. A board which has decided to manufacture bricks has less freedom to decide to make bottles. In a world of scarcity, a decision to do one thing will commit a board to a certain course of action and make it costly and difficult (indeed, sometimes impossible) to change course and do another. This is an inevitable fact of life and is not an abdication of directorial duty.114
The justices thus made clear that something more is required for a
[i]f the market for senior management, in the business judgment of a board, demands significant severance packages, boards will inevitably limit their future range of action by entering into employment agreements. Large severance payments will deter boards, to some extent, from dismissing senior officers. If an independent and informed board, acting in good faith, determines that the services of a particular individual warrant large amounts of money, whether in the form of current salary or severance provisions, the board has made a business judgment.116
Where the consequence of breach is a financial one, the board generally “retains the ultimate freedom to direct the strategy and affairs of the Company.”117 The Grimes case involved “only a rather unusual contract, but not a case of abdication.”118
Politan applied the same legal framework, but held that a plaintiff had pled a
The Grimes and Politan decisions demonstrate yet again that a
d. Improper Delegations: Bally‘s, Clarke, Jackson, Nagy, Field, and ACE
The largest cluster of decisions involve improper delegations of board authority.124 Exercising its power under
Many decisions have considered improper delegation claims.127 A half-dozen are
In Bally‘s, a holding company granted a management company “uninterrupted control of and responsibility for the operation” of a casino, its sole asset.134 The board retained the power to approve the annual budget, but its approval could not be unreasonably withheld. The board also had to approve any debt that exceeded the budget by $1 million, but that approval also could not be unreasonably withheld. Vice Chancellor Jacobs regarded the terms as so restrictive that “the directors have no power to initiate any action regarding the casino.”135 The directors also could not terminate the agreement unless the board first obtained “an opinion of counsel that a failure to terminate the contract would violate the board‘s fiduciary duties . . . .”136 That last provision proved dispositive, because it meant that a lawyer, rather than the board, would determine whether the contract could be terminated.137 Vice Chancellor Jacobs held that the stockholder plaintiff had stated a viable challenge to the management agreement under
In Clarke, a board authorized a corporation to explore selling all of its assets. But rather than determining whether to sell the corporation‘s assets or setting terms for the sale, the board authorized its President and Secretary to determine whether to sell and on what terms, as long as they secured a value in excess of a minimum price.139 The court granted judgment on the pleadings for the plaintiff, finding the resolution resulted in an invalid delegation because “what the officers deem to be in
In Jackson, the board approved a merger agreement that ensured stockholders would receive a specified amount per share in cash, then called for an appraisal that could result in more consideration.141 Justice Berger, then a Vice Chancellor, held that this pricing structure constituted an improper delegation.142 The appraisal provision bound the board to adopt the appraiser‘s decision, and the board‘s act in setting a minimum level of consideration was not enough.143
The Nagy decision was a virtual repeat of Jackson. A board approved a merger agreement that did not specify the consideration stockholders would receive, providing instead that the acquirer would determine the amount after consulting with a financial advisor. Chief Justice Strine, then serving as a Vice Chancellor, relied on Jackson to hold that by approving this mechanism, the board abdicated its duty to determine the merger consideration.144
The decisions in Clarke, Jackson, and Nagy each relied on Field, a pre-Abercrombie decision in which the board approved an agreement to issue stock to a third party in exchange for the third party‘s shares.145 The board directed an appraiser to determine the exchange ratio, subject to a cap and a floor.146 Chancellor Seitz, then serving as a Vice Chancellor, held that “the directors of a Delaware corporation may not delegate, except in such manner as may be explicitly provided by statute, the duty to determine the value of the property acquired as consideration for the issuance of stock.”147 The corporation argued that the directors acted properly by setting an upper and lower bound, but Chancellor Seitz held that the directors must have the final say.148 The appraisal provision violated
The ACE decision applied similar principles, and its holding resembled the outcome in Bally‘s. A target corporation entered into a merger agreement that prohibited its board from talking with potential third-party acquirers unless counsel opined that the board‘s fiduciary duties required engagement (the “No-Talk Provision“).150 When the target corporation tried to terminate the merger agreement to accept a higher bid, the incumbent buyer sought a temporary restraining order to block the termination, claiming the target violated the No-Talk
Taken together, the improper delegation cases demonstrate yet again that a third-party contract can violate
The improper delegation decisions also confirm that improper limitations on board authority need not be framed expressly as board-level restrictions. In Clarke, Field, Jackson, and Nagy, the
e. Merger Agreement Termination Rights: QVC and Omnicare
The next category of cases involves two decisions: QVC and Omnicare.156 Each decision invalidated a provision in a merger agreement that limited the target directors’ ability to fulfill their fiduciary duties by terminating the agreement to accept a higher offer. Both are primarily viewed as decisions about whether fiduciary duties trump contractual restrictions. The
In QVC, the merger agreement contained a suite of provisions that constrained the Pаramount board from terminating the agreement to secure a better
The No-Shop Provision could not validly define or limit the fiduciary duties of the Paramount directors. To the extent that a contract, or a provision thereof, purports to require a board to act or not act in such a fashion as to limit the exercise of fiduciary duties, it is invalid and unenforceable. Despite the arguments of Paramount and Viacom to the contrary, the Paramount directors could not contract away their fiduciary obligations. Since the No-Shop Provision was invalid, Viacom never had any vested contract rights in the provision.161
The decision as a whole evaluated whether the Paramount directors breached their fiduciary duties when selling Paramount.162 Read in that context, the invalidation of the no-shop provision seemed to suggest that directors possessed a magical right to escape a contract if their fiduciary duties required it.
Delaware judges and practitioners engaged with that interpretation of QVC and explained why it could not hold water. Fiduciary status does not give directors “Houdini-like powers to escape from valid contracts.”163 In a less noticed (and less ...
criticized) aspect of Smith v. Van Gorkom,164 the Delaware Supreme Court held that the fiduciaries who had entered into a merger agreement did not have the ability to disregard its terms.165 Only if the directors
A fiduciary analysis, however, only involves the second dimension of Professor Berle’s twice-tested framework. According to his famous formulation,
in every case, corporate action must be twice tested: first, by the technical rules having to do with the existence and proper exercise of the power; second, by equitable rules somewhat analogous to those which apply in favor of a cestui que trust to the trustee’s exercise of wide powers granted to him in the instrument making him a fiduciary.167
Delaware follows the twice-tested rubric.168 The QVC decision could have invalidated the no-shop clause under either the first inquiry (Berle I) or the second (Berle II).
In hindsight, QVC’s observation that “the Paramount directors could not contract away their fiduciary obligations”169 suggests a Berle I violation of
Interpretating that aspect of QVC as resting on a
This decision is not the first to identify
That brings us to the controversial Omnicare decision. There, a target board entered into a merger agreement with a force-the-vote provision and no right to terminate the merger agreement to accept a higher bid.174 When the board approved the merger agreement, the directors knew that the company’s two senior officers held high-vote stock carrying a majority of the outstanding voting power and would be entering into voting agreements with the buyer that made the merger vote a foregone conclusion.175
The majority opinion agreed on both points. The majority analyzed the combination through a fiduciary duty lens and held that the combination was preclusive and therefore failed enhanced scrutiny.178 As an alternative basis for its holding, the high court held that the combination of provisions was unenforceable because it “completely prevented the board from discharging its fiduciary responsibilities to the minority stockholders when Omnicare presented its superior transaction.”179 For support, the court cited QVC and Section 193 of the Restatement.180
Although the majority did not cite
Common wisdom views Omnicare as a punching bag.184 I have suggested that it’s
Regardless of whether one agrees or disagrees with QVC and Omnicare, the decisions underscore the difference between internally focused governance provisions and externally focused commercial provisions. Some agreements include both. The DGCL expressly authorizes merger agreements and spells out what they must address, evidencing that merger agreements affect a corporation’s internal affairs.187 A merger agreement that failed to address the statutorily required items would be invalid under the DGCL. The improper delegation cases involving merger agreements (Jackson, Nagy, and ACE) confirm that
f. Bylaws: AFSCME and Gorman
The next to last category consists of two cases addressing corporate bylaws: AFSCME and Gorman.188 Bylaws are inherently part of a corporation’s internal
In AFSCME, an institutional investor submitted a proposal for a bylaw that would require reimbursement for a stockholder’s reasonable expenses incurred in nominating one or more candidates for election to the board, as long аs the stockholder did not seek to elect a majority slate and at least one of the candidates was elected.191 The corporation asked the SEC for a no-action letter confirming that the corporation could exclude the proposal from its proxy statement. The SEC certified two questions to the Delaware Supreme Court. First, “[i]s the AFSCME Proposal a proper subject for action by shareholders as a matter of Delaware law?”192 Second, “[w]ould the AFSCME Proposal, if adopted, cause [the corporation] to violate any Delaware law to which it is subject?”193
To answer the first question, the justices considered whether stockholders could enact bylaws that limited board authority under
That meant the Delaware Supreme Court had to determine whether the bylaw limited the board’s managerial prerogatives. Focusing on the nature of bylaws generally, the Delaware Supreme Court held that “a proper function of bylaws is not to mandate how the board should decide specific substantive business decisions, but rather, to define the process and procedures by which those decisions are made.”197 Applying this principle, the court explained that a bylaw would be valid if it “establishes or regulates a process for substantive
The Delaware Supreme Court then turned to the second question. As in QVC and Omnicare, the AFSCME decision framed the issue in terms of the directors’ ability to fulfill their fiduciary duties.199 In doing so, however, the justices expressly relied on
The Delaware Supreme Court held that the AFSCME provision was facially invalid because it would “prevent the directors from exercising their full managerial power in circumstances where their fiduciary duties would otherwise require them to deny reimbursement to a dissident slate.”201 The bylaw could not operate legitimately because if the directors already believed that reimbursement was in the best interests of the corporation, then they would approve the reimbursement irrespective of the bylaw. The only scenario in which the bylaw could ever be enforced would be if the directors believed that expenses should not be reimbursed, at which point enforcement would violate
In Gorman, this court relied on AFSCME to invalidate a bylaw that allowed stockholders to remove the incumbent CEO and appoint his successor.202
Officers shall be chosen in such manner and shall hold their offices for such terms as are prescribed by the bylaws or determined by the board of directors or other governing body. Each officer shall hold office until such officer’s successor is elected and qualified or until such officer’s earlier resignation or removal.203
Under the plain language of
The court agreed with the CEO. Quoting from AFSCME, the court held that stockholders “may not directly manage the business and affairs of the corporation, at least without specific authorization in either the statute or the certificate of incorporation.”206 Again quoting from AFSCME, the court held that bylaws “may not ‘mandate how the board should decide specific substantive business decisions . . . .’”207 The court reasoned that “[a] primary way by which a corporate board manages a company is by exercising its independently informed judgment regarding who should conduct the company’s daily business.”208 The court concluded that giving the stockholders the right to remove officers “would unduly constrain the board’s ability to manage the Company.”209
Those outcomes fit with the rest of the
g. Sample
The last category involves just one decision: Sample. That opinion primarily addressed breaches of fiduciary duty, but it ruled on one
The Sample plaintiff challenged self-interested actions by a company’s top three executive officers, who also comprised a majority of its five-member board.210 The board solicited and obtained stockholder approval for (i) a charter amendment that increased the company’s outstanding shares by 46% and (ii) a management compensation plan that would allow the shares to be used to recruit and retain management.211 After securing the favorable stockholder vote, a special committee granted all of the newly authorized shares to the three officers.212
The company’s disclosures did not mention the plan to issue the shares to the officers.213 They also did not discuss a sale of stock by the company’s largest blockholder, who held a 29% stake, to a buyer who already held a 6.8% stake.214 The seller had asked the company to make representations to the buyer to facilitate the sale.215 The company both gave the representations and covenanted to the buyer that the company would not issue any additional
The plaintiff contended that the officers designed and implemented the interested transactions to ensure that they held a dominant block for five years.217 That block would both entrench management against threats and give them a control position to sell for a premium. But the plaintiff also challenged the Equity Capital Restriction as a violation of
The defendants moved to dismiss the complaint under
If a board enters into a five-year exclusive agreement to purchase energy, that necessarily limits its freedom to manage its procurement of energy. But that does not mean that the board has “abdicated” its authority to manage, it means that the board has exercised its authority.219
The court then theorized that the Equity Capital Restriction was likely a common provision that a buyer might demand to protect against dilution.220 That led the court to conclude that a buyer might pay more to receive that protection, such that a company should be able to grant that protection “to obtain a higher price from buyers to the net benefit of the corporation.”221 Those are fair points, but they do not grapple with the essence of a
In a footnote, the Sample court sought to distinguish the plaintiff’s “so-called ‘abdication’ authority” as envisioning “a more extreme situation when the directors can be thought to have given away to a third-party powers that are so crucial tо management that the directors are essentially no longer in control of the corporation.”222 As examples, the court cited Abercrombie, Grimes II, and Quickturn II. The agents agreement in Abercrombie was so encompassing that it could fairly be described as leaving the directors no longer in control of the corporation.223 But neither Grimes nor Quickturn II involved anything of that sort. The Grimes decisions involved CEO severance compensation.224 The Quickturn II decision only involved the redemption of a rights plan.225 As demonstrated by the survey of
That assertion does not account for the many decisions that have ruled on
In a second footnote, the Sample decision went further:
I understand that certain Supreme Court decisions have purported to address board decisions that limit the future flexibility of the board in a starker manner, reflecting a view that such decisions were illegal, not just inequitable. The decision in [Quickturn II], involving a board’s unilateral adoption of a slow-hand poison pill, is an example. But it is easy to reach the same result—namely, a holding that a slow-hand poison pill should be condemned—employing the more nuanced tool of equity. Certainly, that is rather obviously the case in the more extreme instance of a dead-hand poison pill, the only equitable justifications of which would seem to reside in sentiments commonly expressed by dictators seeking to justify their retention of permanent authority in the face of electoral risk (i.e., only they can protect the citizenry). The more controversial majority decision in [Omnicare], also condemned as per se invalid certain actions. But that was in part precisely the reason that the decision was so controversial and drew two well-reasoned dissents. Those actions were specifically authorized by statute and therefore could not be condemned except on equitable grounds.
For present purposes, it is worth noting that both of these decisions were rendered in cases involving board conduct in the mergers and acquisitions context, in which the concern arises that directors may seek to restrict their own authority (or that of their successors) in order to retain control or favor a particular bidder. The Delaware General Corporation Law does not contain provisions that prevent directors from entering into contracts with [third parties] for legitimate reasons simply because those contracts necessarily impinge on the directors’ future freedom to act. If the judiciary invented such a per se rule, directors would be rendered unable to manage, because they would not have the requisite authority to cause the corporation to enter into credible commitments with other actors in commerce.229
The court thus characterized Quickturn II and Omnicare as aberrational, implicitly sullying other
Both statements are true. Neither captures the nature of a
The Sample decision thus stands alone and on dubious ground in arguing for eliminating
2. Lessons From The Decisions
The review of
The
a. The First Step: Is The Challenged Provision Part Of A Governance Arrangement?
To reiterate, the
Delaware‘s corporation law is not what, in a European context, might be called a broad-based company law. Aspects of company law like competition law, labor law, trade, and requirements for the filing of regular disclosures to public investors, are not part of Delaware‘s corporation law. . . . Delaware corporation law governs only the internal affairs of the corporation. In that sense, our law is a specialized form of contract law that governs the relationship between corporate managers—the directors and officers—of corporations, and the stockholders.235
The
Properly understood, the concept of corporate power refers to whether the entity has been granted the ability to engage in a given act. The concept of authorization refers to whether the proper intra-corporate actors or combination of actors, such as the corporation‘s officers, directors, or stockholders, have taken the steps necessary to cause the corporation to take the given act.244
A contract represents the external exercise of corporate power.
At this point, the Company interjects that drawing a distinction between internal governance arrangements and external commercial agreements is impossible. Citing Sample, the Company argues that all contracts are “doctrinally indistinguishable,”245 meaning that to apply
Through this argument, the Company creates a soritical paradox.247 Any contract imposes at least a grain‘s worth of restriction. The Challenged Provisions impose a heap of internal restrictions. The Company equates grains and heaps by contending that to invalidate the Challenged Provisions means no contract could be valid.
But is there really no way to distinguish grains from heaps? Humans in general, and legal professionals in particular, think in categories.248 Categories are based on prototypes, with penumbral cases that move progressively further away from the prototypes.249 There are core cases where the category is clear and increasing fuzziness toward the periphery.250 Take cars and SUVs. We can categorize vehicles based on those prototypes. At first, a Honda CR-V might be puzzling. As we see more crossover vehicles, we can create a new category around that prototype.
Judges and lawyers use the same process for legal reasoning.251 Judges and lawyers examine precedent to find key characteristics, then reason from those precedents to apply the law to a new set of facts. The Sheldon case252 illustrates this methodology. The Delaware Supreme Court identified one precedent that involved a prototypical control group.253 The high court identified a second precedent that involved a prototype of parallel action.254 The facts of Sheldon fell somewhere between the two. The justices compared and contrasted the facts of Sheldon with the prototypes to put the case in the proper category.255
Using prototypes and categories, courts can identify provisions that allocate authority among internal corporate actors and seek to constrain the board. Courts can distinguish those provisions from similar provisions in commercial agreements.
Contracts establishing governance arrangements have salient features that facilitate
One factor is that governance agreements frequently have a statutory grounding in a section of the
A second factor is that the corporation‘s counterparties in a governance agreement hold roles as intra-corporate actors. In a standard commercial contract, the counterparty might be a supplier, customer, or service provider. In a governance arrangement, the counterparties are likely to be officers, directors, stockholders, or their affiliates.
A third factor is that the challenged provisions seek to specify the terms on which intra-corporate actors can authorize the corporation‘s exercise of its corporate power. They may require voting or not voting in a particular way (Abercrombie and Chapin),257 or forbid particular actions that directors otherwise could take (Marmon, Toll Brothers, Quickturn II, and Omnicare).258 Or they may limit the directors ability to act by forcing them to accept or await a determination by another actor (Bally‘s, Clark, Field, Jackson, Nagy, ACE, and QVC).259
A fourth factor is that, unlike a commercial contract, a governance agreement does not readily reveal an underlying commercial exchange. In a services agreement, supply agreement, or credit agreement, the contract reflects a clear exchange of consideration. With governance arrangements, the point is governance. That is not to say that the agreements are invalid because they lack a peppercorn of consideration. Thеy plainly possess that. But the purpose of a governance arrangement is to allocate control rights. The decisions in ACE, QVC, and Omnicare were challenging and remain controversial because they involved provisions in transaction agreements that fell at the intersection of governance and commercial rights.
A fifth and related factor is the relationship between the contractual restrictions and a commercial purpose. In a commercial agreement, features that touch on governance seek to protect the underlying transaction. Credit agreements often contain negative covenants geared towards protecting the lender‘s right to be repaid. Transaction agreements often contain interim operating covenants to ensure that the buyer gets what it contracted to buy. In a commercial agreement, the bargain is the point and the governance rights protect the bargain. In a governance arrangement, the governance rights are the point.
A sixth and related factor is the presumptive remedy for breach. In a commercial agreement, the presumptive remedy will be damages tied to the commercial bargain. The damages remedy permits the
A final factor is duration of the contract and the corporation‘s ability to terminate it. A commercial agreement is more likely to be terminable or to have a limited duration. A governance arrangement is more likely to be enduring, even indefinite. Either the corporation will lack the ability to terminate, or the right will be heavily constrained (Bally‘s, ACE, QVC, and Omnicare).260
Considering these factors when determining whether an agreement qualifies as a governance arrangement does not turn a facial challenge into an as-applied challenge. A facial challenge addresses a provision as it appears in a specific contract. The party making the facial challenge must prove that the provision, as it appears in a particular contract, cannot operate validly under
b. The Second Step: Does The Challenged Provision Improperly Restrict The Board?
If the challenged provision appears in a contract that is part of the corporation‘s governance arrangement, then the court applies the Abercrombie test. At that point, the court must assess whether the provision “[has] the effect of removing from [the] directors in a very substantial way their duty to use their own best judgment on management matters” or “tends to limit in a substantial way the freedom of director decisions on matters of management policy . . . .”263 An agreement can have that effect directly or indirectly.
Less frequently,
Each of these categories only applies to governance agreements. Restrictions that appear in contracts that are not properly regarded as governance arrangements do not give rise to a
c. The Role Of Stockholder Agreements
Under these standards, stockholder agreements are fertile ground for
Stockholder agreements are also challenging because they can accomplish both more and less than other components of the corporate hierarchy. In one sense, stockholder agreements can accomplish more because “when stockholders enter into agreements about how they will exercise stockholder-level rights, . . . [the] individual owners are bargaining over their private property.”273 To that end, the
In another sense, however, stockholder agreements cannot achieve as much as higher components in the corporate hierarchy, and stockholder agreements often fall short when parties try. “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.”275 Under the corporate hierarchy, the
These principles point to a simple test for determining when a provision in a stockholder agreement is not subject to
If a stockholder agreement tries to do more, than the corporate hierarchy and
B. The Challenged Provisions Are Part Of An Internal Governance Arrangement.
For reasons already discussed, the
First, a governance arrangement generally is tied to a section of the
Second, a governance arrangement generally involves intra-corporate actors. Here, all of the Company‘s counterparties are intra-corporate actors. The only parties to the Stockholder Agreement are the Company, Moelis, and three of his affiliates. Moelis is the Company‘s founder, CEO, and Chairman. In substance, the Stockholder Agreement is a bilateral agreement between the Company and Moelis.
Third, the Challenged Provisions attempt to govern how internal corporate actors authorize the exercise of corporate power. The Pre-Approval Requirements constrain Board action. The Board Composition Provisions and the Committee Composition Provision mandate Board or Company action. Except for the Nomination Requirement and the Efforts Requirement, all of the Challenged Provisions purport to bind the Board.
Fourth, there is no evident underlying commercial bargain. When asked about the consideration the Company received, all its lawyers could cite is Moelis’ employment agreement and the conditions embodied in the Secondary Class B Condition.281 Moelis’ employment agreement is a separate
Fifth, because there is no underlying commercial arrangement, the governance features in the Stockholder Agreement are not tied to one. Unlike in Sample, where the Equity Capital Restriction could play a rational role in protecting the buyer‘s interests in purchasing a large block of stock, the Challenged Provisions establish a web of governance rights and constraints.
Sixth, the Board lacks any ability to terminate the Stockholder Agreement. Section 5.1 of the Stockholder Agreement governs termination. It states:
The terms of this Agreement shall terminate, and be of no further force and effect:
(a) upon the mutual consent of all of the parties hereto;
(b) with respect to Holdings, if the Secondary Class B Condition ceases to be satisfied; or
(c) with respect to each Stockholder (other than Holdings), at such time after the Secondary Class B Condition ceases to be satisfied that such Stockholder and its Permitted Transferees who are Stockholders cease to Beneficially Own a Registrable Amount.282
Any non-consensual termination thus depends on the failure of the Secondary Class B Condition.
The elements of the Secondary Class B Condition only include one item nominally within the Board‘s control: If Moelis’ employment agreement is “terminated in accordance with its terms because of a breach of his covenant to devote his primary business time and effort to the business and affairs of the Company and its subsidiaries or because he suffered an Incapacity.”283 But even that item is not truly in the Board‘s control. Whether Moelis devotes his primary business time and effort to the business and affairs of the Company is up to Moelis. Whether Moelis suffers an Incapacity is up to the Fates.284
Not only that, but terminating Moelis is also one of the items where a pre-approval requirement exists. The Stockholder Agreement states that even after the failure of the Class B Condition, as long as the Secondary Class B Condition is satisfied,
the Board shall not authorize, approve or ratify any of the following actions or any plan with respect thereto without the prior approval (which approval may be in the form of an action by written consent) of [Moelis]:
(i) any removal or appointment of the Chief Executive Officer of the Company . . . .285
The Stockholder Agreement thus specifically contemplates that the Board cannot remove Moelis as CEO without his pre-approval while the Secondary Class B
The Board also has no path to terminate the Pre-Approval Requirements by causing the Class B Condition to fail. As with the Secondary Class B Condition, the only source of failure nominally in the Board‘s control would be to terminate Moelis’ employment agreement. How much time and effort Moelis devotes to the Company is up to him, and whether he suffers an Incapacity is not up to the Board. And under the Pre-Approval Requirements, the Board must obtain Moelis’ prior approval for “any removal or appointment of any officer of the Company that is, or would be, subject to Section 16 of the Exchange Act[.]”286 As CEO, Moelis is a Section 16 officer, so his pre-approval is required for his own termination.
At oral argument, Company counsel suggested that no one intended to require Moelis’ pre-approval for his own termination and that the specific language of the employment agreement that allows for its termination should control over the general language in the Stockholder Agreement that requires his pre-approval for the termination of Section 16 officers.287 But the Stockholder Agreement specifically preserves Moelis’ termination as one of the acts that continues to require his pre-approval even after the Class B Condition fails. That is not a more general provision; it is quite specific. The pre-approval requirement for terminating a Section 16 officer
is also quite specific. Plus, it would not make sense if the Company could not terminate Moelis after his ownership fell below the level required to satisfy the Series B Condition, but could terminate him without his consent before the Series B Condition failed, when he had greater ownership and more detailed rights. When the employment agreement and the Stockholder Agreement are read together, the Board must obtain Moelis’ pre-approval under the Stockholder Agreement before exercising any rights the Company has under the employment agreement.
That means the Board has no ability to navigate its way out of the thicket of restrictions imposed by the Stockholder Agreement. That suggests that the purpose of the arrangement is to ensure that Moelis retains control over the Company‘s internal affairs.
Last, a successful action to enforce the Challenged Provisions would likely result in equitable relief, such as an injunction forcing the Board or the Company to act or not act. Because the Challenged Provisions are not tied to an underlying commercial arrangement, it would be difficult for a court to construct a damages remedy for breach. The Challenged Provisions are designed to compel or prevent action, through judicial enforcement if necessary.
The Challenged Provisions serve an obvious purpose. They were included to preserve Moelis’ control, even if he sold enough shares that his voting power dropped below a mathematical majority, as it now has. As long as he controlled a majority of the outstanding voting power, Moelis could elect all of the directors. After he sold down, the Board Composition Provisions would ensure that Moelis could still elect a majority of the Board. And he can continue to do so as long as the Class B Condition is met, which currently allows him to control a majority of the board with beneficial ownership of around 7% of
The Pre-Approval Requirements serve a similar purpose. As long as Moelis held a majority of the outstanding voting power, he could remove the entire Board without cause through action by written consent. That power gave him the practical ability to check any plan the Board might pursue. As he sold down, that power would dissipate. The Pre-Approval Requirements ensure that the Board must continue to obtain Moelis’ pre-approval after Moelis no longer has a majority of the voting power, as long as the Class B Condition is met. The Pre-Approval Requirements also enhance Moelis’ power as a controller. By requiring the Board to get his approval first for a vast swathe of actions, Moelis avoids the potentially explosive implications of removing directors.
The Challenged Provisions are prototypical governance provisions in a prototypical governance agreement. As such, they are part of the Company‘s internal governance arrangement. Even though they appear in a separate contract, they are subject to
C. The Facial Challenge To The Pre-Approval Requirements
Because the Pre-Approval Requirements are part of a governance arrangement, they are subject to the Abercrombie test. The plaintiffs challenge the Pre-Approval Requirements as a whole. The plaintiffs also challenge the requirements individually. This decision need not reach the individual challenges. Taken as a whole, the Pre-Approval Requirements go too far. They facially violate
1. The Pre-Approval Requirements Restrict The Board.
Under Abercrombie, governance restrictions violate
For starters, the Pre-Approval Requirements are not framed as consent rights. They are framed as prohibitions. They identify actions that the Board cannot take unless Moelis gives his approval, in writing, in advance. This is not a setting where “under certain conditions, certain corporate actions cannot be implemented unless they have been approved by both the board and [Moelis],” as the Company argues.294 The Board literally cannot take any of the listed actions or approve “any plan with respect thereto” unless Moelis gives his “prior approval.”295 The Pre-Approval Requirements impose a flat ban on these categories of actions unless Moelis allows them. They make Moelis the gatekeeper to board action.
Assuming that the Company‘s mischaracterization was accurate and that the Pre-Approval Requirements were framed as consent rights, that would not make a difference. A flat prohibition that a counterparty can waive is the mirror image of a requirement to obtain counterparty consent. Both are contractual blocks that the counterparty can decide to enforce. In each case, the right gives another party the ability to prevent action. Both are equally constraining.
The real question is whether a right to prevent the Board from taking action constrains the Board‘s authority. The answer would seem obvious, but the Company insists it is not. The Company argues that the Board can do whatever it wants, it‘s just that sometimes Moelis may disagree. One might as easily tell an inmate in a prison that she is free to do anything she wants, it‘s just that sometimes a prison guard might disagree.
In the real world, “the power to review is the power to decide.”296 “If every decision of A is to be reviewed by B, then all we have really is a shift in the locus of authority from A to B.”297 If another party
The Company argues that unless the plaintiff can point to a present negative or detrimental effect on the Company or its stockholders, then relief must be denied. The ability of humans to anticipate constraint results in a present, negative, and detrimental effect. Just as presidential veto power and the policy goals of the Oval Office shape what Congress views as possible and the bills that end up on the Resolute Desk, so too will the existence of the Pre-Approval Requirements shape the Board‘s sense of the possible and what the directors pursue. The Board and Moelis must interact regularly. Moelis does not just hold the Pre-Approval Requirements. He is the Company‘s CEO, Chairman, and eponymous founder—perhaps the most powerful triad of positions in a company. Doubtless Moelis has preferences. If the directors anticipate that Moelis will not pre-approve a course of action, then they may never suggest it in the first place. If push came to shove on a major issue that threatened the directors’ reputations, livelihoods, or wealth, then they could be expected to take a stand. Short of that, and particularly on issues where reasonable minds can disagree, accommodation is the easier course.300
In an effort to blunt the significance of the Pre-Approval Requirements, the Company represents that Moelis has never exercised them, but that does not defeat the plaintiff‘s facial challenge. Instead, that is powerful evidence that the Pre-Approval Requirements have a chilling effect. The Stockholder Agreеment has been in place for a decade. Think of the myriad issues that the Company has confronted over those years. Yet Moelis and the Board have never disagreed?
In addition to operating as constraints in the real world, the Pre-Approval Requirements qualify as constraints under Delaware law. In Abercrombie, the agents’ agreement did not literally bind the director designees of the corporate stockholders to vote as seven out of eight agents agreed or an arbitrator determined. Instead, the corporate stockholders bound themselves to
use their best efforts to cause their representatives on the Board of Directors . . . to vote . . . as determined by the Agents or by any seven thereof, and that in the event of the failure of any such director so to vote all parties hereto will cooperate and act in any legal manner possible to cause any director voting contrary to any such determination by the Agents to resign or be removed and to be replaced upon the Board of Directors . . . .301
Nevertheless, this provision was invalid as to the other directors “[b]ecause it tends to limit in a substantial way the freedom of director decisions on matters of management policy” and therefore prevents each director from being able “to exercise his own best judgment on matters coming before the board.”302 Chancellor Seitz also noted that a director might feel bound to honor a decision even though it was contrary to his own best judgment.303
The same is true here. In fact, the Pre-Approval Requirements are more pernicious than the Voting Provision in Abercrombie, because they expressly require Moelis’ prior approval before the Board can act. In Abercrombie, the directors other than Davies only faced the threat of removal after the fact.
The Pre-Approval Requirements are so all-encompassing as to render the Board an advisory body. Moelis, not the Company, is running the show. The directors can only act to the extent Moelis lets them. The Pre-Approval Requirements have the effect of removing from the directors in a very substantial way their duty to use their own best judgment on virtually every management matter. They are therefore facially invalid under the Abercrombie test.
2. The Pre-Approval Requirements Cannot Operate Legitimately.
The Company also contends that the plaintiff‘s facial challenge fails because Pre-Approval Requirements can operate legitimately. According to the Company, so long as Moelis does not invoke them, there is no
That argument fails initially because it ignores the deterrent effect of the Pre-Approval Requirements. As discussed in the prior section, the Pre-Approval Requirements loom in the background, forcing the directors to operate at all times in their shadow. The existence of the Pre-Approval Requirements always and necessarily inhibits the exercise of board power.
Setting aside the deterrent effect, the Company argues that the provisions do not formally constrain the Board as long as Moelis and the directors agree. But from that formalistic standpoint, agreement
A similar dynamic existed in AFSCME, where stockholders sought to adopt a bylaw that would require the boаrd to reimburse proxy contest expenses under specific settings. If the board decided to reimburse the expenses on its own initiative, then the proposed bylaw was superfluous. The bylaw only operated to force board action in a setting where the board had decided that the proxy expenses should not be reimbursed.304 The bylaw therefore could not operate validly and was contrary to Delaware law.305
There is no setting in which the Pre-Approval Requirements can operate validly. The facial challenge to the Pre-Approval Requirements therefore succeeds.
D. The Facial Challenge To The Board Composition Provisions
The plaintiff next mounts a facial challenge to the Board Composition Provisions, which seek to constrain the size and composition of the Board. The Board Composition Provisions are therefore part of a governance arrangement to which
There are six Board Composition Provisions: the Size Requirement, the Designation Right, the Nomination Requirement, the Recommendation Requirement, the Efforts Requirement, and the Vacancy Requirement. The Recommendation Requirement, the Vacancy Requirement, and the Size Requirement violate the Abercrombie test, cannot operate legitimately, and are facially invalid. The Designation Right, the Nomination Requirement, and the Efforts Requirement can operate legitimately and so are not facially invalid.
1. The Recommendation Requirement
The Recommendation Requirement is the easiest to address. It mandates that the Board recommend in favor of Moelis’ designees, whoever they might be, by requiring that the Company include Moelis’ designees “in the slate of nominees recommended by the Board.”306 That obligation is facially invalid.
Delaware law on mandating board recommendations is well developed due to disputes over provisions that have attempted to prevent a board from changing its recommendation in favor of a merger.307
Under
“Delaware law requires that a board of directors give a meaningful, current recommendation to stockholders regarding the advisability of a merger including, if necessary, recommending against the merger as a result of subsequent events.”314 This obligation flows from the bedrock principle that “when directors communicate publicly or directly with shareholders about corporate matters, the sine qua non of directors’ fiduciary duty to shareholders is honesty.”315 The duty of loyalty, which mandates that directors act in stockholders’ best interests, consequently “requires ensuring an informed stockholder vote.”316 “A board may not suggest or imply that it is recommending the merger to the shareholders if in fact its members have concluded privately that the deal is not now in the best interest of the shareholders.”317
In light of these principles, “[t]he target board must have an ability to make a truthful and candid recommendation consistent with its fiduciary duties—and this duty will be applicable whether or not there is a superior offer.”318 A target board may not “tie its hands . . . [and]
These principles apply equally to a board recommendation regarding director candidates. A board cannot recommend individuals whom it does not subjectively believe should be directors, and it cannot continue to recommend individuals whom it recommended previously if it no longer recommends them.
The Recommendation Requirement mandates that the Board recommend Moelis’ designees, regardless of what the directors think about them. That obligation violates the Abercrombie test by removing from the directors in a very substantial way their duty to use their own best judgment on a management matter, viz., who should serve as a director.
As with the Pre-Approval Requirements, the Recommendation Requirement cannot operate permissibly. If the Board already supports Moelis’ designees, then the Recommendation Requirement is not doing any work. The Recommendation Requirement does work when the Board opposes one or more of Moelis’ designees. Thus, in every setting where the Recommendation Requirement operates, it violates
2. The Vacancy Requirement
The Vacancy Requirement is the next easiest to address. That obligation is facially invalid as well.
Article FIFTH, Part (5) of the Charter gives the board the exclusive power to fill vacancies. It states:
Subject to the terms of any one or more classes or series of Preferred Stock, any vacancy on the Board of Directors that results from an increase in the number of directors may be filled only by a majority of the Board of Directors then in office, provided that a quorum is present, and any other vacancy occurring on the Board of Directors may be filled only by a majority of the Board of Directors then in office, even if less than a quorum, or by a sole remaining director.320
Article FIFTH, Part (6) makes clear that even if Moelis creates a vacancy, only a majority of the directors then in office can fill it. The relevant portion of that provision states:
[A]t any time the Class B Condition is satisfied, any or all of the directors of the Corporation may be removed from office at any time, with or without cause, by the affirmative vote of the holders of a majority of the voting power of the shares entitled to vote in connection with the election of the directors of the Corporation. The vacancy or vacancies in the Board of Directors caused by any such removal shall be filled as provided in Clause (5) of this Article FIFTH.321
The Bylaws say the same thing about vacancies, albeit without the reference to the possibility of directors elected by particular classes or series of preferred stock.322
The Vacancy Requirement violates the Abercrombie test by removing from the directors in a very substantial way their duty to use their own best judgment on a management matter, viz., who should serve as a director. The Chapin decision is directly on point.323 The only difference between the succession agreement in Chapin and the Vacancy Restriction is that the trustees agreed on specific people to fill vacancies as they arose. Under the Vacancy Requirement, the directors have agreed to accept a person whom Moelis designates. The limitation on the Board‘s power under
As with the Recommendation Requirement, the Vacancy Requirement only operates when Moelis and the Board disagree on who should fill a vacancy. Any board can choose to fill a vacancy with a candidate whom the CEO and Chairman suggests. If the Board decides voluntarily to fill a vacancy with someone Moelis proposes, then the Vacancy Requirement is not compelling the directors to act. The Vacancy Requirement only has teeth if the Board disagrees. In every setting where the Vacancy Requirement operates, it violates
3. The Size Requirement
The Size Requirement mandates that the Company use its best efforts to maintain a Board with not more than eleven seats, unless Moelis approves a different number. At present, that provision cannot operate at all, but that does not mean that it can operate validly. In any setting when the Size Requirement could be invoked, it would be facially invalid.
The Charter establishes a lower and upper bound for the size of the Board and empowers the Board to determine its size by resolution within those parameters. Article FIFTH, Part (3) states: “The Board of Directors shall consist of not less than three (3) nor more than eleven (11) members, the exact number of which shall be fixed from time to time by resolution adopted by the affirmative vote of a majority of the Board of Directors then in office.”325
The Bylaws echo the Charter on this point. Section 3.1(a) of the Bylaws states: “The Board of Directors shall consist of not less than three (3) nor more than
The Size Requirement obligates the Company to use its best efforts “to cause to be elected to the Board, and to cause to continue in office, not more than eleven (11) directors (or such other number of directors as [Moelis] may agree to in writing).” Under this provision, there can be fewer than eleven directors in office, but there cannot be “more than eleven (11) directors (or such other number of directors as [Moelis] may agree to in writing).” The Size Requirement thus establishes a ceiling of eleven seats that the Board cannot exceed without Moelis‘s consent.
At present, the Size Requirement is doing nothing because the Charter and Bylaws prevent the Board from having more than eleven seats. Because the Board is already constrained by those statutorily valid provisions, the Board cannot act to increase the number of seats beyond eleven. The Size Requirement is currently superfluous.
But that does not mean that the Size Requirement is not facially invalid. The Size Requirement can only become operative if the Charter and Bylaws were amended to authorize the Board to have more than eleven seats. At that point, the Size Requirement would violate the Abercrombie test by removing from the directors in a very substantial way their duty to use their own best judgment on a management matter, viz., the size of the Board. The Chapin decision would be on point and establish that the provision was invalid.327
As with the Recommendation Requirement and the Vacancy Requirement, there is no setting where Moelis could invoke the Size Requirement and have it operated validly. The only time it can operate is if (i) the Charter and Bylaws allow more than eleven directors, and (ii) the directors want to expand the Board to have more than eleven seats. Only in that setting does the Size Requirement kick in, and in that setting, it operates invalidly to constrain the Board‘s authority under
4. The Designation Right
The Designation Right enables Moelis to specify individuals as potential candidates for election as director. As long as the Class B Condition is met, Moelis can specify a number of individuals equal to a majority of the seats on the Board. After the Class B Condition fails, Moelis can specify a number of individuals equal to one quarter of the seats on the Board. That provision is not facially invalid.
The Designation Right, standing alone, only gives Moelis the ability to propose a specific number of designees. It does not force the Board or the Company to do anything with the designees. The other Board Composition Provisions determine what, if anything, the Board and the Company have to do with Moelis’ designees.
Viewed in isolation, the Designation Right does not impose any restriction on the Board that could violate
The Nomination Requirement obligates the Company to include the Moelis designees in the Company‘s slate of nominees by “nominating such designees to be elected as directors.”328 That provision is not facially invalid.
Nominating a candidate means enabling them to stand for election.
Recommending a candidate means endorsing their candidacy.
The ability to nominate candidates is an important stockholder right. “The right of shareholders to participate in the voting process includes the right to nominate an opposing slate.”329
The unadorned right to cast a ballot in a contest for cоrporate office is meaningless without the right to participate in selecting the contestants. As the nominating process circumscribes the range of choice to be made, it is a fundamental and outcome-determinative step in the election of officeholders. To allow for voting while maintaining a closed selection process thus renders the former an empty exercise.330
Only the board can give its recommendation to a slate of candidates. Nominating candidates, by contrast, is not a power that the board holds exclusively. Stockholders have the right to nominate candidates as well.
Because stockholders have the right to nominate candidates, they can legitimately bargain with the corporation over the exercise of that right. The bargains they extract could interfere with the board‘s prerogatives under
6. The Efforts Requirement
The Efforts Requirement derives from two provisions in the Governance Agreement.
The Efforts Requirement can legitimately obligate the Company to take ministerial steps to ensure that stockholders can consider Moelis’ nominees and potentially elect them, such as by adding Moelis’ designees to the Company‘s proxy card or by including information about them in the Company‘s proxy statement. Even in a situation where the Board opposed the election of a Moelis designee, those actions would not constitute a meaningful infringement on the Board‘s authority under
Finally, the plaintiff mounts a facial challenge to the Committee Composition Provision. That provision is invalid under
The board of directors may designate 1 or more committees, each committee to consist of 1 or more of the directors of the corporation. The board may designate 1 or more directors as alternate members of any committee, who may replace any absent or disqualified member at any meeting of the committee.333
In plain terms, that section empowers the board to create committees and select the members who will serve on those committees.
The Bylaws confirm that this rule applies to the Company. Section 3.10 states:
The Board of Directors may designate one or more committees, each committee to consist of one or more of the directors of the Corporation. Each member of a committee must meet the requirements for membership, if any, imposed by applicable law and the rules and regulations of any securities exchange or quotation system on which the securities of the Corporation are listed or quoted for trading. The Board of Directors may designate one or more directors as alternate members of any committee, who may replace any absent or disqualified member at any meetings of such committee.
The bylaw provision envisions that the Board both establishes a committee and designates its members.
The Committee Composition Provision violates the Abercrombie test by removing from the directors in a very substantial way their duty to use their own best judgment on a management matter, viz., who should serve on a committee. Under
The Company responds by arguing that to “designate” a committee does not involve appointing its members. The able law firm representing the Company previously reached the opposite conclusion. When asked to address the validity of a bylaw provision that would allow a single director to determine the members of committees, the Company‘s counsel had no difficulty concluding that designating a committee meant selecting its members:
Although
Section 141(c)(2) does not define what it means to “designate” a committee, a court construing this provision would accord the term its plain meaning. See Sostre v. Swift, 603 A.2d 809, 813 (Del. 1992). The plain meaning of “designate” is to select one or more persons to perform a specific duty, i.e., to serve on a committee of the board of directors. See Black‘s Law Dictionary, at 447 (6th ed. 1990) (defining the word “designate” to mean “to indicate, select, appoint, nominate, or set apart for a purpose or duty, as to designate an officer for acommand. To mark out and make known; to point; to name; indicate“).334
In the same letter, the law firm opined that the proposed bylaw was statutorily invalid:
Beyond contravening the express terms of
Section 141(c)(2) , allowing a single director to appoint the members of a board committee would undermine the implicit policy rationale of the statute.Section 141(c)(2) ‘s requirement that the members of a board committee be designated by the board of directors (or a properly authorized committee of the board) is vital to the statutory scheme enabling the use of board committees because it bridges the gap between the use of board committees, which permits board action by select directors, and the general policy that, “to be valid, actions of a board must be taken at a meeting where all members are afforded the opportunity to be present” and “participate fully in the deliberations.” 1 David Drexler et al., Delaware Corporation Law and Practice § 13.01[6], at 13-11 (2007). By operation ofSection 141(c)(2) ‘s requirements, the entire board has the opportunity to participate in establishing the board committee and selecting its members (or in selecting the members of a committee that, in turn, may appoint directors to other board committees). Enabling a single director to appoint the members of a board committee without providing an opportunity for input or participation by the remaining directors essentially substitutes the single director‘s decision for the entire board, thereby subverting the very mechanism that validates the use of board committees.335
That reasoning applies to the Committee Composition Provision.
As with the other facially invalid requirements, the Committee Composition Provision cannot operate legitimately. If the Board voluntarily populates a committee with a proportionate number of Moelis’ designees, then the provision is not doing any work. The Committee Composition Provision only comes into play when Moelis and the Board disagree, at which point the provision prevents the Board from exercising its statutory authority. The Committee Composition Provision is therefore facially invalid.
F. The Policy Arguments
To defend the Challenged Provisions, the Company advances a series of policy arguments. This case does not call for a public policy analysis. When the General Assembly has enacted a statute, that statute embodies Delaware‘s public policy.336 A court is not free to disregard it.
First, the Company suggests that Delaware cases have upheld similar provisions, creating a reliance interest. Citing Sample, the Company argues that “this Court has held that contractual approval rights such as those conferred by [the Pre-Approval Requirеments] are facially valid under [Section] 141(a).”337 That is not true. The Sample decision only considered the Equity Capital Restriction, not a comprehensive suite of provisions like the Pre-Approval Requirements. The Equity Capital Restriction provision appeared in a
The Company also cites decisions involving stockholder agreements that contained features similar to the Challenged Provisions.338 The Company observes that those decisions have not held the provisions invalid. That is because no one challenged them. It would be an extreme step for a court to declare a provision invalid when no one has challenged it. Those decisions do not speak to the validity of the provisions.339
Next, the Company argues that many companies have stockholder agreements containing similar provisions. The Company also points out that settlement agreements resolving proxy contests with activist investors often contain provisions resembling the Board Composition Provisions.
This case does not involve an activist settlement agreement. Any
The Company is correct that other corporations have entered into similar stockholder agreements with favored internal actors. To date, the number of companies using this structure remains low relative to the total number of companies in the market. Ruling on the validity of these provisions now will not be overly disruptive, particularly when statutorily permissible alternatives exist. Instead, addressing the issue now is important because Professor Rauterberg has uncovered a trend. Corporate planners have increasingly turned to stockholder agreements as a means of allowing favored stockholders to maintain control, even at levels where their stock ownership would not support a control finding.340 A standard strategy involves baking in a stockholder agreement containing governance rights when setting up a company for an IPO. That enables the pre-IPO stockholders who are parties to the agreement to sell down over time, while relying on the stockholder agreement to maintain control. If that strategy violates
In any event, market practice is not law. Delaware courts consider market
As its ace in the hole, the Company appeals to private ordering. According to the Company, the court should uphold the Challenged Provisions because of “Delaware‘s general commitment to safeguarding ‘freedom of contract’ and its ‘policy of enforcing the voluntary agreements of sophisticated parties in commerce.‘”342 Even private ordering has its limits. “Corporate law, unlike contract law, is not susceptible to near-infinite customization.”343
As the Delaware Supreme Court recently reiterated, “[o]nly a strong showing that dishonoring [a] contract is required to vindicate a public policy interest even stronger than freedom of contract will induce our courts to ignore unambiguous contractual undertakings.”344
The General Assembly‘s policy choice on this point is a rational one. Stockholders should be able to contract freely about how they will exercise their stockholder level rights.346 But to the extent stockholder agreements seek to impose governance constraints on the board, as new-wave agreements often do, then private ordering must take place through the charter. As Professor Fisch has explained, forcing private ordering into a corporation‘s constitutive documents “restores the legislative and judicial roles in determining the permissible scope of private ordering,” rather than opening the door to an “anything goes” model based on private contracts.347 It also ensures greater visibility and transparency regarding the governance solutions that corporations reach.348 Professor Fisch concludes that “the use of formal governance tools facilitates the transparency of governance innovation, leads to clarification of the law, and permits the spread
Through
The Company‘s approach would eliminate the mediating role that
The fact that there may be statutorily compliant methods to achieve many of the same results does not mean that the Challenged Provisions get a free pass. “When evaluating claimed violations of the DGCL, Delaware law takes a formal and technical approach.”352
[T]he entire field of corporation law has largely to do with formality. Corporations come into existence and are accorded their characteristics, including most importantly limited liability, because of formal acts. Formality has significant utility for business planners and investors. While the essential fiduciary analysis component of corporation law is not formal but substantive, the utility offered by formality in the analysis of our statutes has been a central feature of Delaware corporation law.353
Thus, Delaware courts, “when called upon to construe the technical and carefully drafted provisions of our statutory corporation law, do so with a sensitivity to the importance of the predictability of that law. That sensitivity causes our law, in that setting, to reflect an enhanced respect for the literal statutory language.”354
If the plaintiff had brought an equitable challenge, then the existence of an alternative path could be significant, because “equity regards substance rather than form.”355 When considering statutory compliance,
III. CONCLUSION
When market practice meets a statute, the statute prevails. Market participants must conform their conduct to legal requirements, not the other way around. Of course, the General Assembly could enact a provision stating what stockholder agreements can do. Unless and until it does, the statute controls.
The plaintiff‘s motion for summary judgment is granted as to the facial invalidity of the Pre-Approval Requirements, the Recommendation Requirement, the Vacancy Requirement, and the Size Requirement. The Company‘s motion for summary judgment is granted as to the facial validity of the Designation Right, the Nomination Requirement, and the Efforts Requirement. The motions are otherwise denied.
Within ten days, the parties will submit a joint letter that attaches an agreed-upon form of order implementing the rulings made in this decision and in the Timing Decision. If the parties cannot agree, they will submit a joint letter outlining their disagreements and proposing a path for resolving them.
Notes
After the Class B Condition ceases to be satisfied, for so long as the Secondary Class B Condition is satisfied, the Board shall not authorize, apрrove or ratify any of the following actions or any plan with respect thereto without the prior approval (which approval may be in the form of an action by written consent) of [Moelis]:
(i) any removal or appointment of the Chief Executive Officer of the Company;
(ii) any amendment to the Certificate of Incorporation or Bylaws that materially and adversely affects in a disproportionate manner the rights of Mr. Moelis; or
(iii) any amendment to the Partnership LP Agreement that materially and adversely affects in a disproportionate manner the rights of Mr. Moelis.