Uncertainty on Governance Rights in Stockholders Agreements Continues Pending a Decision in the Appeal of Moelis

Important recent Delaware developments on the issue of the facial validity of governance rights granted by corporations in stockholders agreements have included (i) the issuance by the Court of Chancery of three major decisions (all by Vice Chancellor Laster)—West Palm Beach Firefighters Pension Fund v. Moelis (Feb. 23, 2024); Wagner v. BRP Group (May 28, 2024); and Seavitt v. N-Able, Inc. (July 25, 2024); and (ii) the enactment by the Delaware legislature of amendments to the Delaware General Corporation Law, which became effective August 1, 2024 (the “Amendments”).

• Moelis. In the seminal Moelis decision, the court held that extensive governance rights granted by a Delaware corporation in an internal corporate governance agreement (including a stockholders agreement), rather than granted in the corporate charter, were facially invalid, as such rights violated DGCL Section 141(a)’s mandate that the affairs of Delaware corporations be managed by the board of directors (not key stockholders) unless otherwise provided in the corporation’s charter.
• DGCL Amendments. In response to (among other things) Moelis, the Delaware legislature enacted the Amendments, with the express purpose of overriding the result in Moelis, in order to conform the statute to what practitioners asserted was longstanding market practice in granting governance rights in stockholders agreements. The Amendments provide that, “notwithstanding DGCL Section 141(a),” any and all kinds of governance rights can be granted in stockholders agreements, so long as they do not violate the corporate charter nor would violate Delaware law if they were incorporated into the charter. By their terms, the Amendments are applicable prospectively and retrospectively, but they do not apply to the few cases as to which litigation already was pending (or completed) before the August 1, 2024 effective date of the Amendments.
• Wagner. The Amendments were not applicable in Wagner because the litigation was already pending before August 1, 2024. The court held that, even without the benefit of the Amendments, many of the governance rights granted in the stockholders agreement at issue did not violate DGCL Section 141(a)—because the parties had adopted a novel corporate governance mechanism that effectively returned power to the board over the corporate actions with respect to which the stockholders rights had been granted. Further, however, the court found that some of the rights, separately, violated other specific sections of the DGCL and on that basis were facially invalid.
• Seavitt. The Amendments were not applicable in Seavitt because the litigation was already pending before August 1, 2024. The court held that many of the rights granted in the stockholders agreement at issue were facially invalid as they violated DGCL Section 141(a). The court held, further, however, that many of the rights were facially invalid, separately, on the basis that they violated specific sections of the DGCL other than Section 141(a) and/or violated provisions of the corporation’s charter. For example, the court held that the pre-approval right over mergers violated the “order of operations” set forth in DGCL Section 151 (which required, first, approval by the board and, then, approval by the corporation’s stockholders); and the right to set the size of the board violated the authority of the board to set board size under the corporation’s charter.

Key Points

• Wagner and Seavitt raise an important question about the court’s potential interpretation of the Amendments going forward. The court stressed in Wagner and Seavitt that it was applying “the old law”—and not offering any opinion as to what the result would be if the Amendments had been applicable in these cases. However, the court’s findings in both cases that, irrespective of the validity of certain governance rights under Section 141(a), separately, they were also invalid under other sections of the DGCL raises an important question. In future cases, where the Amendments are applicable, will the court interpret the Amendments as effectively overruling Moelis, Wagner and Seavitt—because the Amendments broadly authorize the granting of governance rights in stockholders agreements? Or, alternatively, will the court, notwithstanding the Amendments, still find certain governance rights in stockholders agreements to be facially invalid—because they violate sections of the DGCL other than Section 141(a) or violate the corporate charter, and the Amendments authorize governance rights in stockholders agreements “notwithstanding Section 141(a)” so long as they do not violate the corporate charter nor would violate Delaware law if included in the charter? Put differently, the question arises whether it would violate Delaware law to include in a corporate charter a governance right that violates a specific section of the DGCL? If so, the court may find in future cases, notwithstanding the Amendments, that many governance rights granted in stockholders agreements are facially invalid. We would note that, arguably, such result would be inapt as it would render the Amendments largely meaningless and contradict the legislative history and purpose. Further certainty awaits the decision on the pending appeal in Moelis, the possible appeal of Wagner or Seavitt, further judicial interpretation of Wagner and Seavitt, future decisions interpreting the Amendments, and the evolution of corporate practices and norms.
• In Seavitt, the court stressed the board’s “gatekeeper role” where the DGCL establishes an “order of operations” requiring board action first. Where the DGCL establishes an order of operations—requiring, for example, first, approval by the board and then approval by the corporation’s stockholders—that order is “fixed,” the court stated, and it establishes an important “gatekeeper role” for the board. A pre-approval right granted to key stockholders in a stockholders agreement, for example with respect to mergers, “usurps” the board’s gatekeeper role by “putting [the key stockholders] at the head of the line” before the board in making a decision about a merger.
• In Seavitt, the court found that the following rights granted in the stockholders agreement at issue violated sections of the DGCL other than Section 141(a) and/or violated the corporation’s charter:
  • Mergers. The court found that a pre-approval right over change-in-control transactions (including mergers) violated the order of operations set forth in Sections 251 and 272. A “two-step process” was required for approval of such transactions—“First, the board of directors must initiate the process and recommend the transaction to stockholders. Only then can the stockholders vote to approve the transaction….”
  • Voluntary liquidation or dissolution. The court found that a pre-approval right over voluntary liquidation or dissolution of the corporation violated the order of operations set forth in Sections 275(a) and (b).
  • Filling vacancies. The court found that a right to require the board to fill vacancies in seats occupied by designees of the key stockholders with other designees of the key stockholders violated Section 223(a), which provides that the board has the exclusive right to fill board vacancies.
  • Committee representation. The court found that a right to require the board to include at least one of the key stockholders’ designees on each committee violated Section 141(c)(2), which empowers the board to create committees and select the members.
  • Removal of classified director. The court found that a right to remove directors from the corporation’s classified board, with or without cause, so long as the key stockholders held at least 30% of the company’s voting shares, violated Section 141(k), which permits removal of a director from a classified board only for cause, and only with the approval of a majority of the shares entitled to vote for directors.
  • Board size. The court found that a right to set the size of the board violated the corporation’s charter, which stated that the board would determine the number of directors.
• In Wagner, the court found that the following rights granted in the stockholders agreement at issue violated sections of the DGCL other than Section 141(a) and/or violated the corporation’s charter: 
  • Charter amendments. The court found that a pre-approval right over charter amendments violated the order of operations set forth in Section 242.
  • Hiring or removing senior officers. The court found that a pre-approval right over actions affecting a senior officer violated Sections 142(b) and (e), which provides that officers shall be chosen and vacancies filled as set forth in the bylaws or determined by the board.

Practice Points

• A corporation granting governance rights in a stockholders agreement should carefully tailor each right to maximize the potential that the court would find it facially valid. Pending further developments on the topic, this effort will require careful analysis, with legal counsel, of (i) all potentially applicable sections of the DGCL, (ii) the company’s charter and bylaw provisions, and (iii) the structure of the rights. We note that many of the rights the court found invalid in Wagner and Seavitt would have been valid, the court seemed to indicate in Wagner, if, rather than having been structured as pre-approval rights, they had required the stockholder party’s approval to come after the statutorily-required approvals by the corporation’s board and its stockholders. Tailoring rights granted to stockholders, to seek to ensure compliance with the DGCL, should be an ongoing process that takes into account the Amendments; the court’s holdings and discussion in Wagner and Seavitt; any further judicial or legislative developments in this area; and the evolution of market practices and norms.
• Continued uncertainty is to be expected. Notwithstanding the Amendments, based on (i) Wagner and Seavitt, (ii) some arguably ambiguous drafting in the Amendments, and (iii) possible fiduciary issues, we expect continued uncertainty as to the validity of governance rights granted in stockholders agreements. Thus, a board still should consider granting any significant governance rights in the charter, or in a “golden share” of preferred stock (if blank-check preferred shares are authorized), to the extent possible. This should be readily accomplished in the context of a company about to go public. Amendment of the charter of an already-public company to provide such rights, however, presents logistical issues in terms of obtaining the necessary stockholder approval; possible fiduciary duty issues related to justifying a grant of rights in a post-IPO context; and, if changes are later desired, the need to obtain stockholder approval at that time to amend the charter. All of these considerations will be affected by the Delaware Supreme Court’s decision in the Moelis appeal.
• Consider structuring governance rights as post-approval (rather than pre-approval) rights where the DGCL establishes an “order of operations” requiring approval by the board first, to be followed by approval of the stockholders. Where the DGCL sets forth an order of operations for board and stockholders’ approval for an action, a company should consider, in lieu of granting key stockholders’ a pre-approval right for such action, granting instead a right to approve that follows any statutorily-required board and stockholder approvals. We expect it should be permissible in this situation, and, depending on the circumstances it may be desirable, to provide also that the stockholder, if requested, would, at the outset of the process, provide to the company an indication as to whether the stockholder would intend, absent changed circumstances, to provide its consent after the board and stockholder approvals are obtained.
• Consider amending the bylaws so that governance rights granted do not conflict with them. In Wagner, the court held that a stockholder’s pre-approval right for actions affecting senior corporate officers violated DGCL Section 142, which provides that certain key actions relating to officers (such as their hiring and firing) can be taken as set forth in the company’s bylaws or as determined by the board. The court emphasized that the company’s bylaws did not authorize a contractual counterparty to control the hiring and firing of the company’s senior officers. Thus, with respect to any governance rights as to which the DGCL permits actions to be taken “as prescribed by the bylaws or determined by the board,” a board should consider providing in the bylaws that such actions can be taken as set forth in any stockholders agreement the company has and/or may enter into. (We note, however, that, in Wagner, the court injected an element of doubt with respect to this approach, stating that the court was not addressing whether “the Charter or the Bylaws could empower a contractual counterparty to control [such matters relating to senior officers], because nothing in the Charter or Bylaws [in this case] purports to allow it.”)
• A charter provision opting out of the Amendments should be specific. The Amendments apply by default to all Delaware corporations, but a corporation can opt out of the applicability, either in whole or with respect to specific issues. In Seavitt, the court found that the Lead Investors’ right in the Stockholders Agreement to set the size of the board was invalid because it conflicted with N-Able’s charter, which stated that the board had the exclusive right to determine the size of the board. Notably, in a footnote, the court wrote: “It is interesting to ponder whether, under the [Amendments], the Charter is sufficiently specific to override Section 122(18) [(i.e., to opt out of the Amendments)] for purposes of the Size Requirement.” The court stated that it could offer no viewpoint on the issue as the Amendments were not applicable in this case. The court’s comment, however, indicates that, to seek to ensure that a charter provision opting out of the Amendments will be effective, it should be sufficiently specific.