Delaware Chancery’s Moelis II Decision Provides Cautionary Tale for Boards and Activists

Key Points

• In West Palm Beach Firefighters’ Pension Fund v. Moelis & Co., No. 2023-0309-JTL (Del. Ch. Feb. 23, 2024) (“Moelis II”), the Delaware Court of Chancery held that a number of provisions in a Stockholder Agreement between a company and its founder were facially invalid, as they unlawfully constrained the board’s discretion in violation of DGCL § 141(a).
• These provisions required the board to obtain the founder’s consent before taking various actions, limited the board’s discretion over the board’s size and composition, and required the board to ensure significant founder representation on all committees. The Court held that, under DGCL § 141(a), such constraints on the board’s ability to exercise its judgment may only be implemented through amending a company’s Certificate of Incorporation.
• The case is likely to embolden challenges to provisions in stockholder and activist settlement agreements that grant a particular investor (or its director designee) special governance rights. 

Summary

On February 23, 2024, Vice Chancellor Travis Laster of the Delaware Court of Chancery issued his 131-page decision in West Palm Beach Firefighters’ Pension Fund v. Moelis & Co., No. 2023-0309-JTL. The case involved a challenge to various provisions of a Stockholder Agreement between a company and its CEO, founder and then-controlling stockholder. Plaintiff, another shareholder, claimed that the challenged provisions violated DGCL § 141(a), which provides that “the business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation.”

After an extensive review of prior case law involving challenges under DGCL § 141(a,), the Court found that courts analyzing such challenges must conduct a two-part inquiry:

(1) Is the challenged provision part of an arrangement that “seek[s] to govern the corporation’s internal affairs,” as opposed to a purely “external commercial agreement”?

a. The Court emphasized that an “internal governance arrangement” can include “internal governance provisions that appear in nominally external agreements, such as stockholder agreements.” The Court identified a number of factors to help identify an “internal governance provision,” including whether the provision: (i) has a statutory grounding in the DGCL; (ii) is agreed to by intra-corporate actors; (iii) seeks to specify how intra-corporate actors exercise corporate power; (iv) reflects “an underlying commercial exchange” or has a “commercial purpose” beyond mere governance rights; (v) provides for a remedy of damages tied to a commercial bargain, rather than an injunctive remedy enforcing governance rights; and (vi) has an indefinite duration and/or cannot be readily terminated by the company. 

(2) If the provision involves an “internal governance arrangement,” courts should apply the so-called Abercrombie test, evaluating 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.”

The Court found that the challenged provisions of the Stockholder Agreement were “prototypical” internal governance provisions, and thus went on to apply the Abercrombie test to each of them.

Applying that test, the Court found that a number of the challenged provisions were facially invalid, as they unlawfully constrained the board’s ability to use its own judgment in violation of DGCL § 141(a). These included provisions requiring the board to:

• Obtain the founder’s consent before taking any of 18 different types of board actions, including, among others: (i) the incurrence of debt above a specified amount, (ii) the issuance of common and preferred stock, (iii) the adoption of a stockholder rights plan, (iv) the removal or appointment of certain officers of the Company (including its founder/CEO), (v) the approval of annual budgets, (vi) the declaration of dividends, and (vii) entering material contracts.
• Recommend that stockholders vote in favor of the founder’s board nominees.
• Use its best efforts to set the size of the board as 11 seats or fewer.
• Fill any vacancy caused by the departure of one of the founder’s board designees with another founder designee.
• “Take all reasonable actions within its control at any given time” to ensure that the board include a proportionate number of the founder’s designees on each board committee.

By contrast, the Court upheld other provisions in the Stockholder Agreement, finding that they did not, on their face, unlawfully restrict the Board’s discretion. The Court left open the possibility that an as-applied challenge to these provisions could succeed in a particular situation. The surviving provisions required the board to:

• Allow the founder to nominate a number of director candidates equal to a majority of the board seats.
• Nominate (as distinct from “recommend”) the founder’s designees as candidates for director elections.
• Make reasonable efforts to ensure that the founder’s designees are elected and continue to serve as directors.

The Court acknowledged the potentially broad impact its decision could have on other stockholder agreements, as well as settlement agreements with activist investors. The Court explained that “addressing the issue now is important” because “corporate planners have increasingly turned to stockholder agreements as a means of allowing favored stockholders to maintain control,” and that “if that strategy violates Section 141(a), then it would be good for corporate planners to know that sooner, rather than later, so they can deploy alternative structures.”

The Court concluded by explaining that DGCL § 141(a) leaves companies a path to impose governance constraints on the board by including those constraints directly in the Certificate of Incorporation, which would have allowed the founder to achieve “the vast majority of what he wanted.” The Court noted, however, that this path has limitations as well. For example, a company cannot include provisions in its Certificate of Incorporation that the DGCL expressly forbids. 

Takeaways

• Vice Chancellor Laster’s Moelis II opinion is subject to appeal and may not be followed by other members of the bench. However, at least in the interim, this case will serve as persuasive authority for courts considering similar issues, and will likely embolden stockholders who seek to challenge contractual provisions giving particular stockholders special governance rights.
• That said, the Court’s decision leaves room for alternative paths to achieve governance goals by amending the company’s Certificate of Incorporation. For example, the Court offered one potential strategy: a company could use its blank check authority to issue a “single golden share” of preferred stock and grant that preferred stock governance rights in its certificate of designations (which forms part of the company’s Certificate of Incorporation). 
• Investment funds preparing stockholder agreements, activist settlement agreements or similar contracts should carefully consider the potential implications of Judge Laster’s decision, and should consider alternative, creative mechanisms to achieve their goals.

Please feel free to contact us to discuss the potential future implications of the Moelis II opinion, and ways in which boards and investors may navigate its holdings in arriving at settlements or other agreements.