Court Overrules Stockholder Agreement

In West Palm Beach Firefighters’ Pension Fund v. Moelis & Co., the Delaware Court of Chancery threw out stockholder agreement provisions that gave the company’s CEO and controlling stockholder broad pre-approval rights over corporate actions.

The decision is subject to appeal, but according to an article in Sidley Austin’s Shareholder Litigation Update, corporations considering contractual provisions that limit director decision-making should take note of it.

Delaware’s General Corporate Law grants management of business and affairs to the board, “except as may be otherwise provided in this chapter or in its certificate of incorporation.”

In the case referenced above, the defendant and its CEO entered into the agreement at issue on the day before the company’s initial public offering. Many of the terms of the agreement were contested in the litigation, including “Pre-Approval Requirements” that made prior written consent of the founder mandatory before the board could authorize 18 different types of actions, among them: incurring debt above a specified amount; issuance of common and preferred stock; adoption of a stockholder rights plan; and removal of certain officers including the CEO.

The plaintiff challenged the validity of the provisions, arguing that they restricted director primacy, and were not included in the certificate of incorporation.

The Chancery Court’s analysis was exhaustive. It paid particular attention to factors that distinguish internal governance arrangements from external commercial arrangements. Internal governance matters are subject to the 1956 Court of Chancery Abercrombie decision, which tests a provision based on whether it substantially undercuts the directors’ duty to use their own best managerial judgment on management policy, or limits their freedom of decision on such matters.

With that framework as a guide, the Court held that Pre-Approval and several other Requirements were facially invalid. It held that those provisions violated the Abercrombie test by denying directors the ability to exercise their judgment freely in the best interests of the stockholders. Other Requirements were found not invalid.

The Court did outline a method by which the company could have achieved a similar result by other means, i.e., using its blank check authority to issue preferred stock and granting that preferred stock governance rights.