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E-MailMarcel Kahan is the George T. Lowy Professor of Law and Edward B. Rock is the Martin Lipton Professor of Law at New York University School of Law. This post is part of the Delaware law series; links to other posts in the series are available here.
Delaware finds itself in a post-Moelis crisis. On the one hand, the Chancery Court’s opinion is a well-supported interpretation of current Delaware law. If DGCL § 141(a) imposes any restrictions at all, the stockholder governance agreement at issue in that case – an agreement that gave founder Ken Moelis almost complete control over corporate decisions and governance – must violate those limits.
On the other hand, there are a host of existing stockholder governance agreements drafted by lawyers following current market practice whose validity has been called into question by the Moelis holding. The resulting uncertainty has led the DSBA’s Corporation Law Council to propose an amendment to DGCL § 118 that provides “bright-line authorization” for provisions of the sort at issue in Moelis.
This proposed amendment, in turn, has elicited opposition by us and others (here, here and here) because of its potentially far reaching effects on Delaware law, as well as because of the uncertainty that it introduces. This controversy, in turn, has complicated the normally smooth process of amending the DGCL.
Is there a solution that validates existing stockholder governance agreements while not destabilizing Delaware corporate law? We think there is: convert proposed DGCL § 122(18) into a safe harbor that validates stockholder governance agreements for three years.
How would this work? Quite simply. As with the current proposed amendment, revised § 122(18) would validate existing (and future) stockholder agreements. But those agreements would only be valid for a period of three years (for existing agreements, three years from enactment of the amendment; for new agreements, three years from entering into the agreement). As a safe harbor, it would not preclude longer term stockholder governance agreements, so long as those agreements were consistent with DGCL § 141(a). But for agreements of less than three years, the issue of consistency with § 141(a) would disappear, thus providing time-limited legal certainty for existing and future stockholder agreements.
For the most important and common stockholder agreements, this three year safe-harbor would be sufficient to accomplish their goals. As far as we can tell, there are currently three principal use-cases for stockholder governance agreements:
- Private equity exits: we understand that when private equity sponsors take portfolio companies public, they often use stockholder governance agreements to maintain a degree of control as they exit their investments. A three year safe-harbor preserves this practice. Longer term control by the private equity sponsor could and should be included in the IPO charter.
- Hedge fund settlements: we understand that stockholder agreements are used to memorialize settlements between firms and hedge funds that include covenants to recommend hedge fund board nominees, to limit the size of the board and other similar governance provisions. Again, a three year safe harbor would validate stockholder agreements of this sort, without changing the long term governance structure of the firm.
- Venture capital financing: we understand that in venture capital financed private companies, governance arrangements are often memorialized in a stockholder agreement in combination with the preferred stock’s certificate of designations, arrangements that generally do not survive an IPO. Here, again, the safe harbor would validate existing stockholder governance agreements for three years, after which they would terminate or be included in the charter or be limited by § 141(a).
By limiting the safe harbor to three years, our proposed compromise preserves the traditional structure of Delaware corporate law. The certificate of incorporation would remain the corporation’s “constitution” and the foundation for corporate governance. Any significant, long-term governance arrangements would have to be included in the charter. In doing so, we preserve DGCL § 141(a)’s traditional role as imposing limits on the delegation of board functions, thereby preserving Delaware’s board-centric system and allowing the law to develop workable limits on delegation through common law adjudication. Our proposal accomplishes all this while providing legal certainty for existing stockholder governance agreements and allowing transactional lawyers the flexibility to experiment with “contractual private ordering.”
The choice of a three year sunset is obviously somewhat arbitrary. If it turns out that 70% of existing agreements would be safe under our three year safe harbor but 95% would be safe under a five year safe harbor, that could be a reason to extend it. On the other hand, if 95% would be safe under a three year safe harbor, that would be a reason to set it at three years.
By including new agreements in the safe harbor, our proposal allows for the continued use of governance agreements in the specific use-cases identified by the proponents of the amendment while limiting the effects on core principles of Delaware law. A time limited safe harbor will, we predict, lead to sorting by deal lawyers: short term arrangements will be set forth in (time-limited) stockholder agreements; longer term arrangements will be put into the charter.
Our proposal would also address some of the process criticisms of the amendments to Section 122. Given the substantial uncertainty relating to a large number of stockholder governance agreements engendered by the Moelis decision, the DSBA’s Corporation Law Council understandably felt a need to act quickly. But in doing so, it drafted an amendment before the Delaware Supreme Court had an opportunity to rule in a Moelis appeal and before some of the substantive criticisms against the proposal could get a full vetting. A three-year safe harbor satisfies the pressing need for immediate clarification and affords time for a Moelis appeal to take its course and for the policy discussion to continue. Beyond that, a three year safe harbor would enable companies with existing shareholder governance agreements to amend their charters to provide for long-term governance arrangements if the board and shareholders determine that doing so would be in the best interest of the company.
We can think of four other approaches to revising the proposed Moelis amendment to provide greater legal certainty for existing agreements while limiting the effects on established principles of Delaware corporate law. First, one could explicitly define the restrictions that can (and cannot) be included in stockholder governance agreements. Second, one could limit the mode of adoption as in MBCA § 7.32’s requirement of unanimous shareholder approval. Third, one could limit stockholder governance agreements to stockholders who hold greater than a given percentage of shares, whether that be 20% or 5% or some other percentage. Fourth, one could limit stockholder governance agreements based on the time of adoption and permit greater flexibility for agreements entered into prior to an IPO.
We believe that our safe harbor approach provides the greatest legal certainty with the least displacement of existing Delaware law, but these other approaches are also worth considering. We understanding that this intervention comes late in the legislative process, maybe too late to be carefully considered in the current legislative session. However, adding a three-year sunset to the proposed § 122(18) would provide at least temporary certainty while preserving the ability for further legislation extending the sunset, or perhaps even eliminating it, after a more careful study of the terms of existing stockholder governance agreements. At the same time, in the event that proposed § 122(18) is adopted as written, we would urge the DSBA’s Corporation Law Council to revisit the desirability of a sunset in January with the benefit of data on those agreements.
