Delaware Chancery Court Invalidates Common Stockholder Agreement Provisions

In the recent decision West Palm Beach Firefighters’ Pension Fund v. Moelis & Company, Vice Chancellor J. Travis Laster of the Delaware Court of Chancery ruled that certain provisions of a stockholder agreement contravened Sections 141(a) and 141(c) of the Delaware General Corporation Law (“DGCL”) by restricting the authority of the board of directors to manage the business and affairs of the corporation. The Moelis decision raises uncertainty regarding the validity of stockholder agreement provisions common to both public and private companies, including stockholder consent rights, board composition provisions, and board committee composition provisions. In addition, the Moelis decision discusses alternative means for accomplishing the purposes of many of the invalidated provisions without violating statutory law—primarily by including such terms in the corporation’s certificate of incorporation.

Here we summarize the factual background of the decision and the legal framework Vice Chancellor Laster provides for evaluating stockholder agreement provisions under Delaware law, and offer practical advice for planning and reviewing stockholder agreements in light of the ruling.

Background

Moelis & Company (“Company”), a global investment bank founded by Ken Moelis, operated as a private entity until it went public in 2014. Just before the Company’s initial public offering, Mr. Moelis and three affiliates entered into a stockholder agreement (“Stockholder Agreement”), which was fully disclosed to investors. The Stockholder Agreement granted Mr. Moelis extensive rights and control over the board of directors of the Company (“Board”) and its actions, including:

• Pre-Approval Requirements: Pre-approval rights over 18 categories of Board actions, such as issuing securities, adopting budgets, incurring indebtedness, entering into new lines of business, removing or appointing certain officers, settling material litigation, and entering into mergers or sales of the Company.
• Board Composition Provisions: The right to determine the size of the Board, the right to designate a majority of the directors, the requirement that the Board nominate Mr. Moelis’ designees, the requirement that the Board recommend that stockholders vote in favor of Mr. Moelis’ designees, the requirement that the Company use reasonable efforts to enable Mr. Moelis’ designees to be elected, and a requirement that the Board fill any vacancy in a seat occupied by a designee of Mr. Moelis with another of his designees.
• Committee Composition Provision: The right to have a proportionate number of designees on any committee of the Board.

The plaintiff, a Company stockholder, filed a lawsuit alleging that these provisions violated Sections 141(a) and 141(c) of the DGCL. Specifically, the plaintiff alleged that these provisions improperly constrained the Board’s authority and duty to manage the Company in its best judgment and in the best interests of its stockholders.

Framework

The court granted partial summary judgment in favor of the plaintiff, holding that most of the challenged provisions were facially invalid under Section 141(a) of the DGCL and the committee composition provision invalid under Section 141(c) of the DGCL. In determining whether a stockholder agreement provision violates Section 141(a) of the DGCL, the court adopted a two-step framework:

1. Internal Governance Arrangement: First, the court must assess whether the challenged provision is part of an internal governance arrangement rather than an external commercial agreement. If it is an external commercial agreement, the inquiry ends and Section 141(a) of the DGCL does not apply.

2. Abercrombie Test: Second, the court must apply the Abercrombie test, which invalidates provisions that substantially limit directors’ judgment on management matters or restrict their freedom in decision-making.

Holding

Applying this two-step framework, the court determined that the Stockholder Agreement constituted an internal governance arrangement, distinct from an external commercial contract. In making this distinction, the court considered several factors,¹ including that the Stockholder Agreement (i) was tied to Section 218 of the DGCL, which specifically authorizes stockholder agreements; (ii) involved intra-corporate actors, namely the Company, its founder, and affiliates; (iii) aimed to govern how internal corporate actors authorize the exercise of corporate power; and (iv) did not involve any exchange of value or performance of services.

The court then reviewed specific provisions of the Stockholder Agreement based on the Abercrombie test:

• Pre-Approval Requirements: These provisions, requiring the Board to obtain Mr. Moelis’ prior consent for significant actions, effectively delegated managerial authority to Mr. Moelis and restricted the Board’s independent judgment.
• Board Composition Provisions: By mandating the Board to maintain a certain size, to recommend that the stockholders vote in favor of Mr. Moelis’ designees and fill seats with Mr. Moelis’ designees, these provisions limited the Board’s discretion over director appointments and vacancies (though the court noted that certain of the other Board composition provisions, as discussed below, were not facially invalid).
• Committee Composition Provision: This provision, requiring a proportionate number of Mr. Moelis’ designees on board committees, violated both Section 141(a) of the DGCL (interference with board discretion) and Section 141(c) of the DGCL (committee formation interference).

The court, however, upheld the validity of three of the board composition provisions: (i) the designation right, which allowed Mr. Moelis to designate a certain number of directors for election based on his percentage of voting power, subject to certain qualifications and limitations; (ii) the nomination requirement, which required the Board to nominate Mr. Moelis’ designees for election as directors; and (iii) the efforts requirement, which required the Company to use reasonable efforts to cause Mr. Moelis’ designees to be elected and continue to serve as directors. According to the court, these provisions did not facially violate Section 141(a) of the DGCL because they only permitted Mr. Moelis to identify director candidates and facilitated the nomination and election process but did not bind the Board to any particular course of action. The court noted, however, that these provisions could still be subject to as-applied challenges if they were used inequitably.

The court also observed that most of the challenged provisions could have been valid if they had been included in the Company’s certificate of incorporation, rather than in the Stockholder Agreement, because Section 141(a) of the DGCL expressly allows for charter-based limitations on board authority. The court suggested that the Board could have used its blank check authority to issue Mr. Moelis a single “golden share” of preferred stock carrying a set of voting and director appointment rights, which would have been part of the Company’s charter. Alternatively, the court indicated that the Board could have incorporated by reference the Stockholder Agreement provisions into the charter as long as the manner in which the provisions would operate was clearly and explicitly set forth in the charter.

Conclusion

In our experience, the provisions of the Stockholder Agreement that the Delaware Court of Chancery objected to are commonly found in stockholder agreements governing affairs of many private and some public companies. Stockholders relying on these agreements to maintain control over the companies in which they invest should consider whether the agreements remain enforceable. As the court stated, “When market practice meets a statute, the statute prevails.”

Mayer Brown can help stockholders execute alternative strategies to implement or retain the governance rights they bargained for.

¹ While distinguishing between external contracts as governance arrangements or commercial contracts involves a matter of degree, the court considered the following seven factors: (1) statutory grounding: Section 218 of the DGCL authorizing stockholder agreements; (2) intra-corporate actors: counterparties were intra-corporate actors (the Company, founder, and affiliates), not external commercial parties; (3) authorization of corporate power: the Stockholder Agreement governed how internal actors authorize corporate power (e.g., voting rights, action approvals); (4) lack of clear commercial exchange: unlike commercial contracts, the Stockholder Agreement lacked a clear underlying commercial exchange; its primary purpose was governance; (5) relationship to commercial purpose: commercial contracts often protect underlying transactions, while governance arrangements focus on governance rights; (6) presumptive remedy for breach: equitable relief (enforcing rights) was the presumptive remedy, emphasizing control rights over commercial damages; and (7) contract duration and termination: governance arrangements tend to be enduring, lacking easy termination compared to many commercial contracts.