Private Ordering and the Role of Shareholder Agreements

Jill Fisch is the Saul A. Fox Distinguished Professor of Business Law at the University of Pennsylvania Law School. This post is based on her recent paper. Related research from the Program on Corporate Governance includes Private Ordering and the Proxy Access Debate by Lucian Bebchuk and Scott Hirst (discussed on the Forum here).

On August 13, 2020, the Delaware Chancery Court issued its decision in Juul Labs, Inc. v. Daniel Grove, 2020 Del. Ch. LEXIS 264, holding that Grove’s statutory right to inspect the books and records of Juul, a Delaware corporation, were limited to those provided by Del. Gen. Corp. L. § 220. The court rejected Grove’s effort, based on the fact that Juul is headquartered in California, to exercise inspection rights pursuant to §1601 of the California statute., holding that stockholder inspection rights are a “core matter of internal corporate affairs” and that, as a result, only Delaware law could apply. The court further held that, pursuant to Juul’s exclusive forum charter provision, any effort by Grove to pursue inspection rights must be litigated in the Delaware Chancery court.

The decision arose from an unusual procedural posture. Grove, a former Juul employee, had acquired his stock pursuant to an option agreement in which he agreed to waive his inspection rights under §220. In an effort to avoid the terms of the agreement, Grove asserted inspection rights under the California statute. Juul then filed an action in Delaware Chancery seeking a declaratory judgment that Delaware and not California law governed Grove’s rights, if any, to inspect Juul’s books and records.

Left unresolved by the decision is the critical question whether Grove validly waived his statutory inspection rights in the underlying shareholder agreement. As Vice-Chancellor Laster noted, the Delaware courts have rejected corporate efforts to use private ordering to limit or eliminate statutory inspection rights, but a line of cases suggests, largely in dicta, that corporate participants may have greater flexibility in a private agreement than in a corporation’s charter and bylaws.

In my paper, Private Ordering and the Role of Shareholder Agreements, I consider the corporate governance question implicated by the facts in Juul: whether corporate participants should be able to use shareholder agreements to structure their corporate governance in ways that would not be permitted in the charter and bylaws. I conclude that courts should reject such efforts in favor of requiring private ordering to take place exclusively through corporations’ formal governance documents—the charter and bylaws.

The paper examines the growing role of shareholder agreements in venture-backed start-ups, corporations like Juul, WeWork and Uber, which raised billions of dollars in private funding without facing the disclosure requirements and price discipline of the public capital markets. The paper argues that these companies differ substantially from the small businesses in which shareholder agreements initially gained acceptance—closely-hold corporations that function largely as incorporated partnerships. The permissible scope and enforceability of shareholder agreements in large private companies, companies in which the investor base and economic impact increasingly resemble those of their publicly-traded peers, is unchartered territory. At the same time, investors and regulators have increasingly discovered that the governance practices of many large private companies are highly problematic, a situation illustrated by the facts revealed in connection with WeWork’s unsuccessful public offering effort.

Shareholder agreements exacerbate the situation. Although shareholder agreements which operate outside the formalities and constraints of traditional corporate law, are used in public companies to a limited extent, they play a far greater role in private companies. There, they are often deployed to reduce the accountability of managers and controlling shareholders and to bypass mechanisms, such as inspection rights, that protect the interests of minority shareholders. As such, they increase the potential for bad governance.

Shareholder agreements also sacrifice the structural advantages of the corporate form, including standardization, predictability and equal treatment of similarly-situated shareholders. They add complexity; indeed, a corporation may have multiple types and versions of shareholder agreements governing the rights of different subsets of the corporation’s shareholders. They purport to bind signatories and to effect waivers of investors’ statutory rights, such as inspection and appraisal, based on principles of actual consent that, as illustrated by the Juul case, are difficult to apply to the take-it-or-leave-it choice faced by an employee or small prospective investor. And, because the use of shareholder agreements is, in most cases, impractical in publicly-traded corporations, decisions that afford corporate participants greater contractual freedom through shareholder agreements have the practical effect of creating a different body of corporate law for private companies and enabling them to avoid otherwise-mandatory features of corporate law.

Although firm-specific private ordering is a desirable feature of corporate law, the paper distinguishes between a contractual approach to corporate governance and displacing corporate law by private contract. It reasons both that the mandatory and structural characteristics of corporate law provide value and that business participants seeking greater contractual freedom can choose an alternative business form such as an LLC or limited partnership. The paper therefore concludes that, in the corporation, private ordering should take place through the charter and bylaws, and that the scope of shareholder agreements outside the close corporation context should be limited to matters that are truly individual in nature. In addition, the paper argues that shareholder agreements should be subject to the traditional hierarchy of governance tools, meaning that a shareholder agreement that is inconsistent with the statute, charter or bylaws, should not be enforceable.

Significantly, the paper recognizes the value of innovative governance provisions such as dual class stock, appraisal waivers, and forum selection bylaws, provisions that, in many cases, have been developed in start-up companies. Courts have generally upheld these provisions in corporate charters and bylaws. To the extent that courts conclude that existing statutory or common law limits these provisions, the appropriate solution is legislation explicitly expanding the permissible scope of private ordering. The Delaware legislature has been particularly responsive to market-based demands for such freedom, as evidenced by its adoption of Del. Gen. Corp. L. §122(17) which authorizes corporations to adopt corporate opportunity doctrine waivers in their charters. From a comparative institutional perspective, legislatures are particularly well-positioned to consider the desirable scope of mandatory corporate law and the interests that it protects.

The complete paper is available for download here.

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