Stockholder Agreement Terms Invalidated by Delaware Court

The Delaware Court of Chancery recently issued an important decision which invalidated multiple provisions of a stockholder agreement. In the case West Palm Beach Firefighters’ Pension Fund v. Moelis & Co., the court found multiple governance provisions in a stockholder agreement between Moelis & Co. and its founder, Ken Moelis, to be facially invalid.

The stockholder agreement, which was entered into at the time of the company’s initial public offering (IPO), contained a number of provisions that gave Ken Moelis a variety of board governance rights.

The decision in the Delaware case has important implications for the structuring of stockholder agreements going forward. In connection with an IPO, it is common for the private equity sponsor or other controlling stockholder to enter into a stockholder agreement with the company going public in order to memorialize certain board governance rights over the company following the IPO. As a result of this court decision, private equity sponsors and other controlling stockholders will have to think more carefully about the provisions they include in a stockholder agreement.

The plaintiffs claimed that the challenged provisions in the stockholder agreement were facially invalid under Delaware General Corporation Law (DGCL) Section 141(a) and Section 141(c), in the case of the committee composition provision.

DGCL Section 141(a) states that “the business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation.”

DGCL Section 141(c) states that “the board may designate committees of 1 or more directors. Any such committee, to the extent provided in the resolutions of the board, or in the bylaws, exercises all the powers of the board, except: (i) approving or adopting, or recommending to the stockholders, any matter (other than the election or removal of directors) expressly required by this chapter to be submitted to stockholders for approval or (ii) adopting, amending or repealing bylaws.”

Based on prior case law, the Delaware Court of Chancery has devised a two pronged test that can be used to determine whether a challenged provision in a stockholder agreement implicates DGCL Section 141(a). The first part of this test requires the court to ask whether the provision in question “constitutes part of the corporation’s internal governance arrangement.” If the answer is yes, the court moves to the second part of the test. The second prong looks to the criteria laid out in the case of Abercrombie v. Davies, which held that governance provisions do not comply with DGCL 141(a) “when they have the effect of removing from directors in a very substantial way their duty to use their own best judgment on management matters” or “tend to limit in a substantial way the freedom of director decisions on matters of management policy.”

The court determined that three categories of Ken Moelis’ board governance rights were facially invalid.

  • Pre-approval rights:

The stockholder agreement was drafted to give Ken Moelis a package of pre-approval rights that spanned 18 different categories of board actions. The actions could not be taken unless Ken Moelis provided written consent in advance. Such company actions requiring pre-approval by Ken Moelis included the incurrence of indebtedness in excess of $20 million, the entry into a new business line requiring an investment in excess of $20 million, the issuance of any preferred stock, and the removal or appointment of any directors or executive officers.

The Delaware Court of Chancery found these pre-approval rights to be excessively constraining, preventing the board of directors from acting based on their own best judgment. The pre-approval rights essentially granted Moelis the ability to unilaterally prevent a number of board actions.

  • Board composition rights:

The court also found that certain provisions of the stockholder agreement relating to the board composition violated DGCL Section 141(a). In particular, the court determined that the requirement that the board recommend in favor of Moelis’ designees for election to the board was facially invalid. The court also determined that the requirement that the board fill any vacancy in a seat formerly occupied by a Moelis designee with another Moelis designee was invalid. Finally, the court determined that the requirement that the company use its best efforts to maintain a board with no more than 11 members was facially invalid because it contradicted the certificate of incorporation and bylaws of the company, which provided that the board can fix the number of directors by a majority vote.

  • Committee representation rights:

The court struck down the provision in the stockholder agreement requiring the board to fill any board committee in proportion to Moelis’ board designee rights, concluding that it violated both DGCL Section 141(a) and Section 141(c). Once again, the court found that this provision prevented the directors from exercising their own best decision-making judgment.

The court determined that the remaining three categories of Ken Moelis’ board governance rights were facially valid.

  • Designation right:

A provision of the stockholder agreement that provided Moelis with the ability to specify particular director candidates was upheld by the Delaware Court of Chancery because it did not force the board to do anything with respect to such designees.

  • Nomination right:

A provision of the stockholder agreement that required the company to nominate Moelis designees for election to the board was deemed valid because it did not force the board to recommend the board candidate.

  • Efforts requirement:

Finally, certain provisions of the stockholder agreement that obligated the company to use reasonable best efforts to cause Moelis board candidates to be elected to the board was upheld. The court determined that such provisions did not meaningfully infringe upon the board of director’s authority.

While this recent Delaware court case has implications for how stockholder agreements are structured in the future, one key takeaway is that certain governance rights deemed invalid in a stockholder agreement may be deemed valid in the company’s certificate of incorporation. The court explicitly noted in its ruling that many of the provisions that were found to be invalid in the stockholder agreement between Ken Moelis and the company would have be deemed valid if included in the company’s certificate of incorporation.