Proposed DGCL § 122(18), Long-term Investors, and the Hollowing Out of DGCL § 141(a)

Delaware is on the verge of gutting DGCL § 141(a)’s iconic principle of board-centricity: “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.” If the proposed DGCL § 122(18) is adopted by the Delaware legislature, § 141(a) will no longer impose meaningful limits on a board’s ability to delegate key governance functions and responsibilities. If such a change is to be made, it should only occur after the Delaware Supreme Court has had a chance to review the Moelis opinion on appeal, only after extensive deliberation among key stakeholders, and only after all of its implications are sorted out. To make such a major change in response to a group of transactional lawyers frustrated by a recent Court of Chancery opinion threatens Delaware’s legitimacy as the de facto promulgator of U.S. corporate law.

Background

In West Palm Beach Firefighters’ Pension Fund v. Moelis & Company, the Delaware Chancery Court held that a stockholder agreement that provided founder Ken Moelis with comprehensive governance rights was void because it was inconsistent with DGCL § 141(a).  Mr. Moelis’ rights under the stockholder agreement included “pre-approval” rights, director designation rights and committee composition rights. Among the pre-approval rights was a requirement that the board not pursue a variety of actions without Mr. Moelis’s prior approval including “the entry into any merger, consolidation, recapitalization, liquidation, or sale of the Company or all or substantially all of the assets of the Company or consummation of a similar transaction involving the Company.”

The opinion has caused considerable consternation among a group of transactional lawyers because it raises doubts about the validity of a current market practice in which significant governance provisions are apparently included in stockholder agreements rather than in the certificate of incorporation (“COI). In response to that consternation, the Delaware Bar Association’s Executive Committee, upon recommendation of its Corporation Law Council, has proposed amending the General Corporate Law to add § 122(18) to provide “bright-line authorization” for provisions of the sort at issue in Moelis. In particular, the proposed amendment to § 122 provides in relevant part that:

Every corporation created under this chapter shall have the power, whether or not so provided in the certificate of incorporation, to: . . .

(18) Notwithstanding § 141(a) of this title, make contracts with one or more current or prospective stockholders (or one or more beneficial owners of stock), in its or their capacity as such, in exchange for such minimum consideration as determined by the board of directors (which may include inducing stockholders or beneficial owners of stock to take, or refrain from taking, one or more actions); provided that no provision of such contract shall be enforceable against the corporation to the extent such contract provision is contrary to the certificate of incorporation or would be contrary to the laws of this State (other than § 115 of this title) if included in the certificate of incorporation. Without limiting the provisions that may be included in any such contracts, the corporation may agree to: (a) restrict or prohibit itself from taking actions specified in the contract, (b) require the approval or consent of one or more persons or bodies before the corporation may take actions specified in the contract (which persons or bodies may include the board of directors or one or more current or future directors, stockholders or beneficial owners of stock of the corporation), and (c) covenant that the corporation or one or more persons or bodies will take, or refrain from taking, actions specified in the contract (which persons or bodies may include the board of directors or one or more current or future directors, stockholders or beneficial owners of stock of the corporation).

We oppose this amendment for two main reasons.

Dual-Class by Another Route?

First, we think that providing “bright-line authorization” for stockholder agreements that contain the aggregate of provisions at issue in the Moelis case would substantially disadvantage long term investors. Currently, for a powerful founder to have full control rights – of the sorts granted to Mr. Moelis – a company must put those provisions into the COI for all to see. In the current environment, it is difficult to grant such control rights after a company has gone public. First, stock exchange listing requirements prohibit mid-stream dual-class recapitalizations. Second, institutional investors’ opposition would doom the stockholder vote required for an amendment. By contrast, if new § 122(18) is enacted, a company will be able to go public with a single-class capital structure and then, after the company is already public, confer comprehensive control rights by contract on a powerful founder without any stockholder vote. Stockholders’ only protection would be a fiduciary duty suit against the directors who approved the agreement. Long term investors – whether they object to dual class capital structures or not — should find this very troubling and should pay particular attention to whether and how a company can commit in its pre-IPO COI not to do so.

Undermining § 141(a)’s Traditional Limits on Board Delegation

Second, new § 122(18), by rejecting DGCL § 141(a)’s traditional limitations on board delegation, will introduce a fundamental change into Delaware law without adequate examination. DGCL § 141(a) has long been the heart of Delaware’s “board centric” governance system. Thus, for example, “dead hand” and “slow hand” shareholder rights plans (a/k/a “poison pills”) were held to be invalid because, by giving greater power to one group of directors over other directors, the provisions were inconsistent with § 141(a) unless included in the COI (Quickturn Design Systems, Inc. v. Shapiro, 721 A.2d 1281 (Del. 1998); Carmody v. Toll Brothers, Inc., 723 A.2d 1180 (Del. Ch. 1998)). Similarly, bylaws providing for mandatory reimbursement of proxy expenses were held to be invalid because inconsistent with § 141(a), again unless included in the COI (CA, Inc. v. AFSCME Employees Pension Plan, 953 A.2d 227 (Del. 2008)).

The stockholder agreement at issue in Moelis, as the vice chancellor points out, is a comprehensive delegation of board responsibilities: “The Challenged Provisions look like something a law professor dreamed up for students to use as a prototypical Section 141(a) violation.” To reject this holding is to reject the idea that § 141(a) imposes any limits on “private ordering.” In doing so, the amendment authorizing Ken Moelis type stockholder agreements will infuse the DGCL with the “freedom of contracting” approach of the LLC Act. The only restrictions that would then remain would be a matter of fiduciary duties and whatever “public policy” exceptions there are to contractual freedom. This may or may not be a good idea. But because it is such a major change in Delaware corporate law, it requires deep consideration.

The Potential Implications of § 122(18)’s Transformation of § 141(a)

Consider the implications of abandoning this approach by reviewing the limits that the traditional interpretation of § 141(a) has imposed on “private ordering.”

First, it could allow boards to impose significant limits on stockholder power by effectively removing § 141(a)’s limitations on such efforts. In Quickturn, the Delaware Supreme Court prohibited “slow hand” poison pills (which limited newly elected directors’ ability to redeem a poison pill) “because the Delayed Redemption Provision impermissibly circumscribes the board’s statutory power under Section 141(a) and the directors’ ability to fulfill their concomitant fiduciary duties.”

What, then, will protect against “slow hand’ and “dead hand” poison pills after § 122(18)? According to the synopsis, “new § 122(18) would not change the outcome in cases [such as Quickturn, Carmody and CA] that invalidated bylaws, and other arrangements, where consideration had not been provided to the corporation and the provisions at issue conflicted with § 141(a) of this title.”

But this is a weak and ad hoc limitation in a statute that begins “Notwithstanding § 141(a) of this title . . .” While a “lack of consideration” limitation may be a plausible discriminating factor for distinguishing commercial from non-commercial contracts, it is easily avoided or manipulated. As the standard first year Contracts class demonstrates, “consideration” provides few limits when, e.g., reliance interests count as “consideration.” Indeed, any competent transactional lawyer could restructure a delayed redemption provision to involve consideration. But, worse, “lack of consideration” is not the reason that “dead hand” or “slow hand” pills are unacceptable. The objection to such pills, as the Delaware Supreme Court explained above, is the inconsistency with § 141(a).

Second, this new “contractual freedom,” untethered to limits imposed by § 141(a), could and, to be consistent, should provide stockholders with much greater freedom to set the “rules of the game,” as Lucian Bebchuk has argued.  Under DGCL § 109, stockholders have broad, inherent powers to adopt, amend or repeal bylaws so long as they are not inconsistent “with law or with the certificate of incorporation.” In Teamsters v. Fleming Companies, 975 P.2d 207 (Okl. 1999), the Oklahoma Supreme Court held that under Oklahoma’s corporate law (which gives stockholder a right to adopt bylaws similar to DGCL § 109), a stockholder adopted bylaw could impose restrictions on a board’s ability to issue rights plans. Would such a bylaw be valid under DGCL § 109? Prior to § 122(18), many took the view that, in light of cases like Quickturn and Carmody, a Delaware court would view such a mandatory bylaw as inconsistent with § 141(a). But post § 122(18), why should that be the case? Stockholder’s inherent right to adopt, amend or repeal bylaws is protected by § 109 so long as the bylaws do not contain any provision inconsistent “with law or with the certificate of incorporation.” With § 122(18) having abandoned the statutory limits on private ordering imposed by § 141(a), and permitting the unlimited delegation of governance rights by stockholder agreement, in what way would such a bylaw be inconsistent with § 141(a)?

Finally, the synopsis emphasizes the principle that, notwithstanding agreements with stockholders on governance terms, the board will still have a role in deciding whether to breach the agreement, and may have a fiduciary obligation to do so. If taken seriously, this obligation to consider breaching corporate contracts has wide reaching implications, and will create confusion about the scope and content of fiduciary duties (not to mention the value of such stockholder agreements). While the text provides “bright-line” authorization of governance provisions, the synopsis accompanying the amendment provides that

New § 122(18) does not relieve any directors, officers or stockholders of any fiduciary duties they owe to the corporation or its stockholders, including with respect to deciding to cause the corporation to enter into a contract with a stockholder or beneficial owner of stock and with respect to deciding whether to perform, or cause the corporation to perform, or to breach, the contract, whether in connection with their management of the corporation’s business and affairs in the ordinary course or their approval of extraordinary transactions, such as a sale of the corporation.

How will contractual governance rights fit with fiduciary duties? To what extent should new § 122(18) – and the validation of broad governance agreements such as the agreement at issue in Moelis – affect the advice provided to boards? We think the somewhat surprising answer should be some combination of “who knows?” and “almost not at all.”

According to the synopsis, we should not worry about the delegation of governance by stockholder agreement because, in any corporate decision, the board will have to consider the costs of breaching the governance agreement as simply one more cost of doing business. We are skeptical that this will actually happen. Contrary to what law and economics theorists may preach, most business people feel an obligation to abide by contracts and are unconvinced by the theory of “efficient breach.” One should expect the typical director to take seriously the stockholder agreements with the corporation and do his or her best to abide by them.

But even if a board is filled with law & economic theorists looking for an opportunity to engage in “efficient breach,” how will a board calculate what those costs will be? On the one hand, as Karen Chesley points out, “consent rights have proven notoriously difficult to value” and typically require determining the outcome of a purely hypothetical negotiation. On the other hand, damages for “efficient breach” could be very large if the corporation is liable for a counter-party’s full expectation damages. In practice, the possibility of a very large damage remedy will likely discourage counterparties from entering into a transaction with the firm over the objections of the Ken Moelis type controller. A counterparty may also worry about a suit alleging tortious interference with contract as in the notorious 1985 Texaco Pennzoil litigation, and will have no assurance that contractual disputes will be subject to Delaware law or receive a Delaware forum.

Open Questions

If this analysis is correct, there are a variety of implications. First, the same analysis would apply to any board decision addressed by a stockholder agreement, including both day to day management as well as transformative transactions like a going private merger. In each case, the contract damages potentially arising from breach of the stockholders agreement will have to be taken into account as an additional cost of pursuing a course of action, but the stockholder agreement should have no significance beyond that.

Second, control rights granted by contract pursuant to § 122(18) stockholder agreements are far less robust or durable or predictable than control rights created by dual class capital structures. Entered into with the corporation, the synopsis claims that stockholder agreements will not be enforceable against a board that may have a fiduciary duty to breach when doing so is in the interests of the stockholders.

Third, a stockholder agreement may render a counterparty a “controller” with all of the accompanying fiduciary obligations but far fewer of the benefits. The likelihood of a court finding that the counterparty is a controller is enhanced in two circumstances: (a) when pre-approval rights are so extensive that they arguably confer a high degree of general control to the counterparty (as in Moelis); (b) when pre-approval rights can be specifically enforced or when they, as a practical matter, deter an efficient breach, they arguably confer transaction-specific control on the counterparty.  In that regard, pre-approval rights differ from covenants in credit agreements. Credit agreement covenants are not nearly as extensive as those in Moelis, are generally not subject to specific enforcement, and will ordinarily not deter an efficient breach. Indeed, the risk of “lender liability” discourages creditors from contracting for significant control rights. Likewise, the risk of fiduciary liability should discourage stockholders from doing so.

Fourth, the complexity and uncertainty introduced by broad stockholder agreements will complicate the disclosure of “risk factors” in a registration statement and other disclosure documents.

Conclusion

It may be that the limitations on delegation that have traditionally been found in § 141(a) have outlived their usefulness as “contractarian” approaches have become more accepted in Delaware corporations. There have certainly been powerful arguments made over the years for doing so. But surely such a major move should only be taken after substantial thought with input from all stakeholders. The Delaware General Assembly should hold off until after the Delaware Supreme Court has had an opportunity to address these issues. This would allow critics of the Moelis decision to submit amicus briefs that describe the market confusion supposedly introduced by the Chancery Court’s decision and to suggest ways to ameliorate that confusion. It would also allow the appellant and other supporters of the Moelis decision to explain why preserving § 141(a) as an outer limit on the delegation of board responsibilities is appropriate. This sort of reasoned process is surely a better way to develop Delaware law than a hasty legislative change driven by a group of deal lawyers frustrated by a Delaware Chancery Court opinion.

Delaware’s legitimacy as the de facto national corporate law-giver derives from its expert judges impartially interpreting and applying its rich store of case law to concrete and complex factual disputes, not from the superiority of its legislature. To the extent that U.S. corporate law is the product of Delaware interest group politics, it is hard to see why Congress or the S.E.C. should defer.