Drag-Along Provisions and Covenants Not to Sue in the Private Company M&A Context

Vice Chancellor J. Travis Laster of the Delaware Court of Chancery recently issued a decision addressing whether a covenant not to sue set forth in a stockholders’ agreement is enforceable under Delaware law, with the result that a stockholder would be precluded from challenging a sale of the corporation. [1] Such covenants have become increasingly common among private companies, and the covenant in this case was based on a National Venture Capital Association form.

The court concluded that as a general matter, such covenants not to sue are enforceable under Delaware law, but that the circumstances in an individual case will matter and such covenants cannot protect boards of directors and other defendants from liability for intentionally harmful conduct. In this case, the court determined that because the underlying allegations could support claims for intentional misconduct by the board and a controlling stockholder, the covenant not to sue could not serve as a basis to dismiss the claims.

Background of the Decision

The case stemmed from a 2022 sale of a private company and involved the following set of facts, as taken from the complaint. Before the sale materialized, the company needed funding, but appeared to have limited options either for funding or a liquidity event. The company accordingly undertook a financing round and recapitalization, pursuant to which certain investors purchased new preferred stock in the company, all existing preferred stock was converted to common stock, and certain existing stockholders (including the plaintiffs in this case) signed a stockholders’ agreement containing a drag-along provision and the relevant covenant not to sue. Two independent directors subsequently resigned, leaving only two directors who were affiliated with the lead investor and the company’s chief executive officer on the board. After the round was completed, the board members granted themselves stock options, which would later result in a 3,200 percent return in the sale of the company. Soon after the round closed, the company received an unexpected inquiry from the buyer in this case to acquire the company for $120 million. Following the receipt of that inquiry, the insiders obtained stockholder approval to extend the prior round and issued additional stock, including to themselves, but failed to disclose the possibility of the sale to the stockholders. The sale of the company ultimately gave the participants in the round and extension a nearly 750 percent return on their investment.

The plaintiffs in this case, well-known venture capital firms, learned the full scale of the facts by bringing a books and records demand. The plaintiffs subsequently filed the litigation against the board and the lead investor, alleging that the directors and the investor, as a controlling stockholder, had breached their fiduciary duties in connection with the sale of the company and the preceding transactions. In an earlier decision in the litigation, the court held that the claims adequately alleged a breach of fiduciary duties. [2] In this case, the issue was whether the covenant not to sue—to which the plaintiffs had agreed—would serve as a separate defense for dismissing the claims.

The covenant not to sue was set forth in a customary drag-along provision in a stockholders’ agreement, which provided that if specified board and stockholder approvals were obtained, the signatory stockholders agreed to take various actions in support of the transaction, including voting in favor of the transaction. The covenant not to sue itself provided, in pertinent part, that each signatory stockholder would refrain from exercising appraisal rights or “asserting any claim or commencing any suit” challenging a sale of the company or the stockholders’ agreement or “alleging a breach of any fiduciary duty…in connection with the evaluation, negotiation or entry into” a sale of the company or the consummation of a sale, but only if the transaction met certain requirements specified in the stockholders’ agreement.

The Court’s Conclusions

The court spent the bulk of its 129-page opinion reviewing various strains of Delaware law and academic commentary to determine whether such a covenant not to sue is facially valid under Delaware law. The court decided that it is, reasoning that, on balance, Delaware law permits the sort of private ordering and tailoring of fiduciary behavior reflected in such a covenant, when set forth in an agreement among stockholders. Among other things, the court emphasized various aspects of the Delaware corporate statute permitting private ordering, a recent decision from the Delaware Supreme Court upholding a waiver of appraisal rights by a sophisticated stockholder in a similar stockholders’ agreement, [3] and the ability under Delaware law to waive constitutional and other significant rights. The court in turn rejected the plaintiffs’ argument that Delaware corporations, in contrast to alternative entities such as limited liability companies, involve inalterable rules pertaining to fiduciary conduct, particularly the duty of loyalty implicated in this case.

Beyond facial validity, however, the court concluded that, in each given instance in which a covenant not to sue is invoked, the Delaware courts will examine the particular facts to determine whether the covenant should be enforceable. For one, the covenant not to sue “must be narrowly tailored to address a specific transaction that otherwise would constitute a breach of fiduciary duty.” The court determined that such requirement was met here, given that the drag-along at issue, as is common, addressed particular types of sales that would receive certain board and stockholder approvals and had to meet certain requirements. In addition, the court concluded that the facts in a given case must support a conclusion that the covenant is reasonable on an as-applied basis, taking into account such factors as whether there is a written contract formed through actual consent, a clearly stated covenant, “knowledgeable stockholders who understood the provision’s implications,” an ability to reject the provision, and the presence of bargained-for consideration. The court concluded that such requirements were met here, particularly given the plaintiffs’ sophistication. In different circumstances, according to the court, a “proponent of a provision like the [c]ovenant would face deep skepticism and a steep uphill slog.”

Nonetheless, the court ultimately determined that the covenant not to sue would not serve as a basis to dismiss the claims in this case. Citing Delaware public policy, the court held that a contractual covenant cannot exonerate defendants from tort liability—including fiduciary duty claims—where they cause harm intentionally. The court concluded that the allegations suggested the possibility of such conduct here and would not be barred by the covenant not to sue. By contrast, if the litigation ultimately shows that “the defendants engaged in self-interested transactions but believed in good faith that the transactions were not contrary to the best interests of the Company, then the [c]ovenant forecloses those claims.”

Takeaways

Given the court’s conclusion that covenants not to sue are generally enforceable under Delaware law, we will, pending any appeal in the case, continue to see their inclusion in stockholders’ agreements and drag-along provisions for the purpose of mitigating stockholder litigation that could impede a sale of the company in the future, and the market may continue to innovate within the parameters described in this case. That said, the case, along with other recent Delaware case law, reflects that Delaware courts will review such covenants on a case-by-case basis, taking into account how the covenant is written, the nature of the stockholder plaintiff, and the circumstances in the case. The case also stands for the proposition, again consistent with other Delaware decisions, that if a fiduciary duty breach is severe enough, a covenant not to sue and a drag-along provision may not foreclose a claim.

Given these considerations, in any particular transaction, the parties should consider whether the use of a drag-along provision and the reliance on a covenant not to sue are advisable. For additional discussion on this topic, please see our prior client alert: https://www.wsgr.com/en/insights/how-to-navigate-the-decision-of-exercising-drag-along-rights-during-an-manda-process.html.

Beyond the enforceability of a covenant not to sue, the case is a reminder that stockholder litigation can and does arise over private company M&A and other transactions involving private companies and that such litigation can be hard to dismiss given the potential conflicts of interest and facts that can exist in the private company context. Private company boards undertaking a sale process should understand that Delaware courts focus on process—for example, the existence and role of independent directors, the quality of disclosures to stockholders, the proper use of outside advisers, directors’ understanding of their fiduciary duties, and whether directors negotiated for the sake of the disinterested stockholders. The board should, accordingly, work with counsel to design a deliberative process that, while practical, protects the board and other defendants from stockholder litigation as much as possible should litigation arise.

Endnotes

1New Enter. Assocs. 14, L.P. v. Rich, C.A. No. 2022-0406-JTL.(go back)

2New Enter. Assocs. 14, L.P. v. Rich, 2023 WL 2417271 (Del. Ch. Mar. 9, 2023).(go back)

3Manti Holdings, LLC v. Authentix Acquisition Co., 261 A.3d 1199 (Del. 2021).(go back)