Rethinking Shareholders’ Agreements in M&A After Chordia v. Lee

The Delaware Court of Chancery’s opinion in Chordia v. Lee provides a cautionary tale for dealmakers in negotiating shareholders’ agreements in M&A (mergers and acquisitions) and performing under those transaction agreements post-closing.  

The underlying transaction in Chordia follows a common fact pattern. The founders and sellers (key holders) of target company Alphonso, Inc. agreed to cede control of the company to a buyer in exchange for a sizeable upfront payment and certain limited liquidity and minority governance rights. These rights included board representation rights, which were conditioned on the continuing employment of at least one key holder. These terms were set forth in a stockholders’ agreement that went into effect at closing.

Following the closing, the story took a more unusual turn. In response to an ongoing pattern of problematic conduct by certain principal key holders, the company’s new majority owner eventually terminated all key holder employees. Their dismissal resulted in the key holders losing their board representation rights under the stockholders’ agreement and permitted the majority owner to remove all key holders from the board.

The key holders sued, and the court ultimately reinstated their board designation rights, holding that the company’s termination of certain key holder employees had violated an “efforts clause” in the stockholders’ agreement. 

Key Provisions in the Stockholders’ Agreement

The Chordia opinion turned on the company’s conduct post-closing in connection with these key provisions in the stockholders’ agreement:

• Director Designation. The key holders were entitled to designate a minority number of directors on the company’s board, subject to two conditions: (i) the key holders’ company stock ownership had to meet a certain threshold and (ii) at least one key holder had to be an employee or officer of the company.
• Efforts Clause. The company agreed “to use its reasonable efforts … to ensure that the rights granted under [the stockholders’ agreement] are effective and that the Parties enjoy the benefits of [the stockholders’ agreement].” The company was specifically obligated under this provision to use its reasonable efforts “to cause the nomination and election of the directors as provided in [the stockholders’ agreement].”
• Employment of Executive Officers. The board maintained the exclusive right to fire executive officers of the company but was not empowered to otherwise terminate employees.

Following the transaction’s closing, the relationship between the company founders and the company’s new majority owner soured. Certain founders acted unprofessionally, defied directives from the board and new majority owner, and were often disruptive in meetings. As a result, the new majority owner decided to terminate the employment of all key holders, which at the time included five executive officers and two non-executive employees, so that the new owner could remove the key holder-designated board members.

The board was vested with the “exclusive right” under the stockholders’ agreement to terminate the five executive officers, but not the two non-executive employees. The board therefore appointed a new chief executive officer (CEO) to terminate the employment of the two non-executive key holders, both of whom continued to make valuable contributions to the company.

The Court’s Surprise Move

The Court of Chancery found that the CEO’s termination of the non-executive key holders’ employment breached the efforts clause in the stockholders’ agreement. While the court recognized that this holding impacted other contractual rights of the company, the court ultimately held that, in terminating the non-executive key holder employees without cause and for the board’s express purpose of eliminating the key holders’ director designation rights, the company failed to use its reasonable efforts “to ensure that the rights granted [to the key holders] under the [stockholders’] agreement are effective … .”

As a result, the court held that the two improperly terminated non-executive key holders retained board designation rights notwithstanding the fact that no key holders remained employed by the company.

Key Takeaways:

1. Drafting Efforts Clauses. This decision regarding shareholders’ agreements in M&A is notable because it turned on a broad reading of a fairly common provision. Going forward, drafters of efforts clauses primarily intended to secure certain procedural cooperation by a company should ensure that these clauses are narrowly drafted to preclude a broader reading.

2. Post-Closing Conduct. Perhaps the most significant takeaway from this case is the extent to which the Chordia holding was no doubt precipitated by the parties’ post-closing conduct. Even when a buyer expressly negotiates for near-total control of a company post-close, the scope of that control may nevertheless be limited by the manner in which it is exercised. If a buyer blatantly acts to the detriment of a minority owner — for example, as evidenced by the CEO’s testimony that he was blindly following orders in terminating the non-executive key holders — even well-drafted contractual provisions can come under fire.The court made a point of discussing the various alternatives available to the company instead of moving straight to terminate the non-executive key holder employees, which indicates that the company’s failure to pursue these options further informed the court’s ultimate holding. Transaction documents should always be accompanied by thoughtful and defensible conduct in exercising any rights provided for thereunder.

3. Court of Equity.  This case serves as an important reminder that the Court of Chancery is a court of equity. The court appeared to find post-closing conduct on both sides of the transaction to be lacking, with one exception — the key holders who were ultimately protected by the court’s holding were valuable contributors to the company. Essentially, artful drafting will not save parties from their own conduct that the court finds to be inequitable or contrary to the purposes of the underlying agreements.

Bass, Berry & Sims attorneys Britt Latham and Emily Connally also contributed to this article.