Important Chancery Decision Upends Practice of Providing Certain Governance Rights in Stockholder Agreements—Moelis

In West Palm Beach Firefighters Pension Fund v. Moelis & Co. (Feb. 24, 2024), the Delaware Court of Chancery invalidated numerous provisions of the stockholders agreement (the "Stockholders Agreement") between Ken Moelis ("Moelis") and Moelis & Company (the "Company"), which granted extensive governance rights to Moelis that allegedly divested control from the Company's board of directors. The Stockholders Agreement had been entered into, and fully disclosed, just before the Company went public in 2014. Under the court's analysis, it appears that many stockholder agreements with Delaware corporations (public or private) that provide governance rights to stockholders, such as founders or pre-IPO investors, and which arguably divest control from, or unduly constrain the exercise of decision-making by, a company's board, may be invalid-raising an issue for the parties to these commonly used agreements, and potentially to certain other corporate agreements that provide for such rights, as to how best to proceed.

Key Points

• The court held that the governance rights provided in the Stockholders Agreement violate DGCL Section 141(a) and therefore are invalid. Section 141(a) mandates that a Delaware corporation's business and affairs be managed by the board except to the extent provided otherwise in the company's charter. The court wrote: "Internal corporate governance arrangements that…deprive boards of a significant portion of their authority" over management matters, and that appear in a stockholder agreement rather than in the charter, contravene Section 141(a).
  
  
• The decision indicates that even a single governance right that divests control from, or unduly constrains the exercise of decision making by, a company's board may violate Section 141(a). The court stated that it considered the governance rights in the Stockholders Agreement "in combination" and was not expressing a view as to whether a lesser set of government rights might have passed muster. We note, however, that the court's discussion underscores that even a single governance right granted in a stockholder agreement can violate Section 141(a). Indeed, The court held invalid (i) all of the challenged pre-approval rights (considered in combination); (ii) three of the six challenged board composition provisions (which required that the board recommend the stockholder's nominees for a majority of the board seats; fill vacancies in seats held by his designees with his designees; and not change the size of the board); and (iii) the requirement that all board committees be populated with the stockholder's designees in the same proportion as his designees serving on the board.
  
  
• The court stated that there are alternative routes to providing substantially the same governance rights via charter amendment or issuance of a "golden share" of preferred stock. These routes appear to be more readily available to private corporations (including ones about to go public). Particularly in the context of a corporation that is already public, (i) as the court acknowledged, a charter amendment may not be feasible because such amendments require stockholder approval, and stockholders likely would not approve it; and (ii) importantly, issuance of a golden preferred share may raise significant fiduciary duty and other issues for the board (as discussed in further detail below).
  
  
• The decision implicates agreements other than stockholder agreements. The court established that Section 141(a) applies only to "internal governance agreements," and not to voting agreements among stockholders, nor generally to "external commercial agreements" (such as credit agreements) even if they grant some governance rights. The court noted, however, a "line-drawing issue" for agreements that may not be readily categorized-including, for example, merger agreements. Section 141(a) will apply to provisions where "governance is the point," but not to those where governance rights are provided to "protect the [commercial] bargain," the court stated. The court expressly left open whether governance rights granted in activist settlement agreements would be subject to the same analysis as in Moelis. We note a likelihood of difficulty with such line-drawing, given that many corporate arrangements include both governance and commercial terms and the flexibility of financial instruments to blur the lines between equity and debt.
  
  
• The court acknowledged that the decision will be "highly disruptive" to market practice. The court wrote: "[W]hen the seemingly irresistible force of market practice meets the traditionally immovable object of statutory law,…the court must uphold the law, so the statute prevails." We note that the court took the same approach in another surprising recent decision, Ap-Fonden v. Activision, issued Feb. 29, 2024, in which the court held that completely standard practices followed by Activision's board, when approving its merger agreement with Microsoft, violated multiple sections of the DGCL (we will be issuing a Briefing on that decision shortly). Indeed, reaction to these decisions has focused on concerns about reduced predictability under Delaware corporate law. In this connection, we note also the recent TripAdvisor decision, in which the court held that a reincorporation from Delaware to Nevada involving a controlled company was subject to entire fairness review.
  
  
• Companies should consider potential steps in response to the decision. We note that the decision may be appealed. It is also possible that the Delaware legislature will consider amending the DGCL to provide guidance as to what restrictions on corporate boards would be permissible under Section 141(a) (as the court requested in the Moelis opinion). Pending these developments, litigation challenging existing stockholder agreements is likely. Parties to stockholder agreements with Delaware corporations should consider whether the rights provided may violate Section 141(a) under the analysis in Moelis; whether to pursue replication of the rights through an amendment setting forth the rights in the charter or through issuance of a golden share of preferred stock; and attendant disclosure issues. Parties putting into place an arrangement de novo generally should do so in the corporation's charter. (See "Practice Points" below.)
  
  

Background. Moelis is the founder, CEO and Chair of the Company, a global boutique investment bank. After years of successfully operating the bank as a private entity, Moelis decided to raise capital from the public markets. One day before the shares began trading publicly, Moelis and the Company entered into the Stockholders Agreement, which grants extensive governance rights to Moelis and ensures his control even after his equity ownership falls well below a majority of the outstanding shares. Immediately after the company's IPO, Moelis owned 96.8% of the Company's equity. Currently, his equity interest is about 6.5% (with rights to obtain additional shares that would bring it to 11.5%), and through some super-voting shares his voting power is at about 40.4%. The plaintiff-stockholder brought suit claiming that the Stockholders Agreement violates DGCL Section 141(a) and is therefore invalid. Vice Chancellor J. Travis Laster granted the plaintiff summary judgment.

The Stockholders Agreement provides as follows:

• "Pre-Approval Rights":The board cannot, without Moelis' prior written approval, approve specified actions listed under 18 different categories ("encompass[ing] virtually everything that the Board can do," the court wrote)-including removing or appointing executives, incurring debt, issuing stock, paying dividends, entering new lines of business, adopting annual budgets and business plans, bringing lawsuits, signing material contracts, and changing the company's name.
  
  
• "Board Composition Provisions":Moelis can designate nominees for a majority of the board seats (the "Designation Right); and the board must nominate his designees (the "Nomination Requirement"), must recommend that stockholders vote in favor of them (the "Recommendation Requirement"), and must use reasonable best efforts to enable their election (the "Efforts Requirement"). The board must fill any vacancy in a seat occupied by a Moelis designee with another person designated by Moelis (the "Vacancy Requirement"). The board size cannot be more than 11 seats (the "Size Requirement").
  
  
• "Committee Composition Provisions": The board must populate any committee with a number of Moelis' designees proportionate to the number of his designees on the full board. (Thus, the board cannot create an independent committee without Moelis designees.)

Discussion

The court stated that current corporate practice must yield to statutory law. The court acknowledged that "[c]orporate planners now regularly implement internal governance arrangements through stockholder agreements providing favored stockholders with extensive veto rights and other restrictions on corporate action." However, the court emphasized, Section 141(a) mandates 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." Notwithstanding the "highly disruptive" effect of this decision on market practice, the court stated, under the long-standing, Delaware Supreme Court-endorsed Abercrombie test, "governance restrictions violate Section 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 stated that valid alternative routes were available to the Company at the time of its IPO for providing substantially the same rights to Moelis. In lieu of adopting the Stockholders Agreement, the court stated, the Company's board could have implemented the "vast majority" of the governance rights, without violating Section 141(a), through (i) an amendment of the Company's charter to set forth the governance rights in the charter or (ii) issuance of a golden preferred share (i.e., a share of preferred stock that carries governance rights but no economic interest) (in which case the certificate of designations for the preferred stock would become part of the charter). The court observed: "Although some might find it counterintuitive that the DGCL would prohibit one means of accomplishing a goal while allowing another, that is what the doctrine of independent legal significance contemplates."

The court stated that "even now" the Company's board likely could provide substantially the same rights to Moelis through issuance of a golden preferred share-however, we note that such action has fiduciary implications that must be considered. The court acknowledged that, once a corporation is already public, amendment of the charter is not feasible as stockholders are unlikely to approve it. We would note also that issuance of a golden preferred share to replicate rights previously granted to a stockholder may raise fiduciary duty issues and, in the case of listed companies, potentially may give rise to considerations under the stock exchanges' voting rights policies. The complex issues surrounding a board's fiduciary duties and stock exchange voting rights policies in these circumstances should be discussed with legal counsel, but may be manageable. (See "Practice Points" below.)

When does Section 141(a) apply to agreements containing governance provisions? We note, first, that Section 141(a) applies only to Delaware corporations (not alternative entities such as LLCs). Second, we note that the DGCL expressly authorizes corporations to enter into contracts, without making any distinction between commercial contracts and internal governance contracts. However, the court determined that the precedential Section 141(a) cases establish-although, the court acknowledged, none of these decisions has ever explicitly articulated as much-that Section 141(a) applies only to agreements and provisions "that seek to govern the corporation's internal affairs," and not to "external commercial agreements."The Stockholders Agreement, the court stated, clearly is "part of an internal governance arrangement" and therefore is subject to Section 141(a). The court acknowledged that it is not always clear whether an agreement is a governance agreement or a commercial agreement, as many types of agreements include a combination of both governance and commercial features. In these situations, the court stated, there is a "line-drawing challenge" to determine to which provisions Section 141(a) applies, and the critical inquiry is whether "governance is the point" or, instead, governance rights are provided to "protect the [commercial] bargain."

The court suggested that the following factors that tend to indicate a governance (rather than a commercial) agreement or provision: (i) the agreement or provision is grounded in a section of the DGCL (such as stockholder agreements that are grounded in DGCL Section 218(c) and (d), or rights plans in Sections 151 and 157); (ii) the corporation's counterparties hold roles as intra-corporate actors (often an officer, director, or stockholder of the corporation, or their affiliates) rather than being, say, suppliers or customers; (iii) the agreement or provision seeks to specify the terms on which intra-corporate actors can authorize the corporation's exercise of its corporate power (such as requiring voting or not voting in a particular way, forbidding particular actions the directors otherwise could take, or limiting directors' acts by forcing them to accept or await a determination by another actor); (iv) there is no obvious commercial exchange; (v) the relationship between the provision and any commercial purpose emphasizes the governance rights, rather than seeking to protect the underlying transaction (again, "governance is the point," rather than "the governance rights protect[ing] the bargain"; (vi) the presumptive remedy for breach will be equitable relief (i.e., ordering or prohibiting certain action), rather than damages; and (vii) the agreement or provision is "enduring, even indefinite," with the corporation lacking the ability to terminate it or being heavily constrained in doing so.

When do governance provisions violate Section 141(a)? As noted, the court applied the Abercrombie test to determine this and found that the Stockholders Agreement did not meet the test. The court wrote: "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." Further, the Board Composition Provisions mean that the directors have to "keep Moelis in control at the Board-level" and cannot use their best judgment when recommending candidates, filling vacancies, determining the size of the board, or creating committees. Indeed, the board has to obtain Moelis' consent "before taking virtually any meaningful action" and can "manage the Company only to the extent Moelis gives them permission to do so"-meaning that "the Board is not really a board." Notably, the court observed that the precedential Section 141(a) decisions confirm that a Section 141(a) problem can arise even if the restriction at issue does not deprive a board of all of its authority, or is not framed expressly as a board-level restriction. For example, the court explained, a Section 141(a) problem can arise from the board delegating a core function to someone else and agreeing to be bound by that person's determination; or from agreeing not to terminate an agreement unless, as a condition precedent, legal counsel determines the board's fiduciary duties require it to do so.

Stockholder agreements are "fertile ground for Section 141(a) violations." The court wrote: "Once parties to a stockholder agreement start addressing governance issues,they can easily move beyond agreements about allocating rights appurtenant to theirshares and transition to internal governance issues." The court suggested asking the following question as "a simple test" to determine whether a provision in a stockholder agreement is subject to Section 141(a): "Does the contractual provision address an action that a stockholder individually or a group of stockholders collectively could take?" If yes, then a stockholder "gets to choose whether to exercise those rights and can agree contractually to constrain its exercise of those rights. If a stockholder agreement tries to do more,…Section 141(a) may invalidate the attempt." As noted, Vice Chancellor Laster suggested in the opinion that Section 218(c) be amended to provide "greater statutory guidance…to address uncertainty about questions involving restrictions on board power."

The court identified which of the challenged provisions in the Stockholders Agreement violated Section 141(a). The court held that the Pre-Approval Requirements (considered in combination), and three of the six Board Composition Provisions (the Recommendation Requirement, the Vacancy Requirement, and the Size Requirement) violated Section 141(a). The court held that three of the challenged provisions did not violate Section 141(a). These were: (i) The Designation Right-as anyone can designate nominees, the court stated, it is "[w]hat the Board or the Company does with those candidates [that] is what matters." (ii) The Nomination Requirement-as "Moelis could nominate his designees at a stockholder meeting, and the Company can agree…to facilitate that process," the court stated. (iii) The Efforts Requirement-as such efforts, the court stated, could properly include actions such as including the names on a proxy card or providing disclosures about the individuals in the proxy statement. The court noted that, while there could be "as-applied challenges" to these three provisions, they were not facially invalid. Importantly, however, as noted, the court held that the Recommendation Requirement was not permissible-as it compelled the board to "recommend in favor of Moelis' designees, whoever they might be."

The court expressly rejected the defendants' arguments that:

• Every contract constrains a board's action. The defendants argued that, for example, entering into an exclusive supply contract constrains the board from entering into other supply arrangements; and as it cannot be that all contracts violate Section 141(a), it must be that none do. The court rejected this as "a version of the soritical paradox," and stressed that the court could "differentiate between an internal governance arrangement and an external commercial contract."
  
  
• The challenged provisions do not restrict the board from acting. The defendants argued that "the Board can do whatever it wants, it's just that sometimes Moelis may disagree." The court responded: "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."
  
  
• The challenged provisions simply provide veto rights. The defendants argued that the Pre-Approval Requirements did not prevent the board from exercising its power as they were only veto rights. The court responded that they were not veto rights but "pre-approval" rights. Even if they were veto rights however, the court stated, that "would not change anything." The provisions "still would give Moelis the ability to block virtually anything the Board might do…. In the real world, the power to review is the power to decide"; and, moreover, "the existence of the Pre-Approval Requirements shape the Board's sense of the possible and what the directors pursue"-if the directors anticipate that Moelis will not pre-approve a course of action, they may never suggest it in the first place.
  
  
• The Pre-Approval Requirements have little significance. The defendants argued that the rights have little significanceas Moelis has never exercised them. The court responded that, to the contrary, this was "powerful evidence" of the chilling effect the Pre-Approval Requirements had. "Think of the myriad issues that the Company has confronted over those years. Yet Moelis and the Board have never disagreed? The best deterrents are never used."
  
  
• Invalidating the challenged provisions would be "highly disruptive." to market practice. The defendants emphasized the disruptive effect on market practice. The court responded that "market practice is not law"; stated that the decision would not be "overly disruptive" given that "statutorily permissible alternatives exist"; and stated that "it would be good for corporate planners to know…sooner, rather than later" if the common strategy of "baking in" governance rights to a stockholders agreement is invalid under Section 141(a).
  
  
• Delaware public policy favors private ordering. The defendants emphasized Delaware's commitment to safeguarding freedom of contract. The court responded that the ability to engage in private ordering remains subject to the limitations imposed by the DGCL, and, when the private ordering involves restricting board authority, "the tailoring must take place in the charter."

Practice Points

• Existing agreements between stockholders and a Delaware corporation that grant governance rights should be reviewed for possible non-compliance with Section 141(a) under the analysis set forth in Moelis. Further developments-from possible appeal of the decision, future court decisions in similar cases (which are already pending), or amendment of the DGCL-may provide additional guidance to inform parties' decisions how to proceed if it appears the rights granted may violate Section 141(a). Pending such guidance, how parties should proceed will depend on a variety of factors particular to the specific facts and circumstances. The available responses include: (i) the company could do nothing, at least pending further judicial or legislative guidance or pending being sued; (ii) the company or the stockholder could seek to negotiate revised (more limited) rights that would comply with Section 141(a); or (iii) the stockholder or the company could seek to engage in discussions about replicating the existing rights in an amendment setting forth the rights in the charter or through issuance of a golden preferred share.
  
  
• As a practical matter, there are significant issues and considerations for a publiccompany in connection with granting governance rights in a stockholder agreement that may violate Section 141(a) or replicating such rights that are in an existing stockholder agreement. We note that alternative entities (i.e., non-corporations) are not affected by Moelis. Also, private corporations and those about to go public should be able to grant governance rights through an amendment to the company's charter that sets forth the rights in the charter, or through issuance of a golden preferred share carrying the rights, and, as noted, should also be able to replicate the rights in any existing stockholder agreement through those same routes. For public companies, however, these routes may present more significant issues.
  • Alternative entities (such as LLCs). Section 141(a) does not apply to alternative entities. Accordingly, an alternative entity can keep in place any existing agreement granting governance rights (or put into place any new agreement that it wants to), notwithstanding the Moelis decision.
    
    
  • A private corporation about to go public. In the case of a company about to go public, in connection with the IPO, governance rights that go beyond what is permitted under Section 141(a) can be granted to a specified stockholder (subject to IPO considerations) in the charter of the company that will become public or through issuance by that company of a golden preferred share. Consideration also could be given to providing control (instead or in addition) through issuance of dual-class voting stock.
    
    
  • A private corporation (not about to go public) or an already public corporation-board fiduciary issues and stockholder approval. In either a private or public corporation context, the company can grant stockholder governance rights that go beyond what is permitted under Section 141(a), or can validly replicate such rights that are in an existing stockholder agreement, either through an amendment to the company's charter such that the rights are set forth in the charter or through issuance of a golden preferred share carrying the rights. However, both board and stockholder approval would be required to take either such action-except that stockholder approval would not be required to issue a golden preferred share if the company has blank-check preferred stock authorized. Importantly, board approval would be subject to the directors' fiduciary duties to the other stockholders, which, depending on the circumstances, if challenged in litigation, could be reviewable under enhanced scrutiny or entire fairness standards (rather than deferential business judgment review).
    
    
  • Key differences between the private and public corporation contexts. (i) In the public company context, stockholder approval is likely to be very difficult to obtain as a practical matter (at least absent a "sweetener" to the stockholders), while it generally should be easier to obtain in the private company context. In the private company context, even if some stockholders may want something in exchange for agreeing to a grant or replication of governance rights, there likely will be fewer stockholders to deal with and they may be more inclined to be cooperative in the process than would be the case in a public company context. (ii) In the public company context, as a practical matter there is likely to be a greater risk of litigation challenging a grant or replication of governance rights. (iii) In the public company context, the company will need to consider the voting rights policy of the exchange on which the company's shares are listed.

• Board fiduciary duties when replicating governance rights. When determining whether to replicate for a stockholder the rights set forth in an existing stockholder agreement that may violate Section 141(a), a board, in satisfying its fiduciary duties to the other stockholders, could consider, for example, (i) any contractual obligation it has under a further assurances provision in the existing stockholder agreement, and/or (ii) the benefits to the company, even at the current time, of ensuring the stockholder's continued, productive involvement with the company (particularly if, say, there are other contractual arrangements between the company and the stockholder, such as support agreements or agreements granting the company the right to use the stockholder's name only under specified circumstances).
  
  
• Other considerations in determining a response to the Moelis decision:
  
  • Stockholder's need for the rights. We note that a stockholder who has control without the stockholder agreement rights does not need those rights to control. He may therefore agree to termination of the stockholder agreement, or revision of the agreement to provide more limited rights that would clearly be compliant with Section 141(a). Of course, his control then would not be ensured into the future when the other bases for his control (such as equity ownership) may no longer be present. Similarly, a stockholder (whether a controller or not) may determine that the rights that it required and obtained at the IPO (or some other stage) may no longer be necessary given factors such as the stockholder's current equity ownership and/or its relations with the board having been friendly.
    
    
  • Rights already in the charter. If any of the stockholder agreement rights are already also set forth in the charter,those rights (which would not violate Section 141(a) because they are in the charter) may be sufficient such that the stockholder would agree to terminate the stockholder agreement. The disadvantage of the rights being only in the charter, however, is that any amendments in the future would be subject to approval of the stockholders (which likely would be difficult to obtain).
    
  • Specific language in the agreement. To the extent rights in an existing agreement are expressly subject to the board's fiduciary duties (or, potentially, otherwise subject to the board's exercise of discretion and judgment), those rights may not violate Section 141(a).

• Parties to stockholder agreements that may violate Section 141(a) should consider any ramifications for the company's disclosure. To the extent that the agreement has been disclosed, depending on the circumstances, consideration should be given, for example, to disclosing that the agreement is being reviewed to determine compliance with Section 141(a), that the company is considering what actions to take in light of the Moelis decision, or that the company has determined to take certain action with respect to the agreement.
  
  
• Parties to merger agreements, activist settlement agreements, as well as other corporate arrangements under which governance rights are granted, must keep in mind the "line-drawing" issues presented under Moelis. As discussed, the court observed that many types of agreements contain both governance and commercial features, and pointed to merger agreements and activist settlement agreements as examples. Parties to such agreements should consider adding language to the relevant provisions (such as, in a merger agreement, provisions that limit the target directors' discretion, in fulfilling their fiduciary duties, to terminate the agreement to accept a superior offer) to seek to clarify that the parties' intention is not primarily governance-related but primarily to protect the commercial arrangement.

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