In a new (May 2, 2023) decision in New Enterprise Associates 14 LP v. Rich [Fugue], C.A. No. 2022-0406-JTL, the Delaware Court of Chancery addressed a motion to dismiss claims for breach of fiduciary duty based on a covenant not to sue. While the Court concluded that such covenants are not generally, or facially, invalid, the Court found that the scope of the covenant in this case excluded what would be permissible under Delaware law (i.e., intentional harms cannot be exculpated). Accordingly, the Court denied the motion to dismiss.
As noted at the outset, the Court’s “decision grapples with a conflict between two elemental forces of Delaware corporate law: private ordering and fiduciary accountability. Ordinarily, those forces operate harmoniously. Here, they pull in opposite directions.”
The plaintiffs were investment funds that invested in a startup company. Years after funding the company, the plaintiffs sought a liquidity event, but no buyer was identified after a search by the company. The company then needed capital, and company’s management represented that the only option was a recapitalization led by another stockholder (the “Recapitalization”), where that stockholder would only commit to fund the company “if (i) all existing preferred stock became common stock, (ii) [he] and his fellow investors received a new class of preferred stock (the ‘Preferred Stock’), and (iii) the Funds and other significant investors executed a voting agreement (the ‘Voting Agreement’ …).”
The Voting Agreement contained a drag-along right, providing that if the company’s board and the holders of a majority of the Preferred Stock approve a transaction that meets certain specified criteria, then all of the signatories to the Voting Agreement must participate (the “Drag-Along Sale”). The plaintiffs accepted the terms of the Recapitalization and, notably, covenanted not to sue the stockholder leading the Recapitalization or his affiliates and associates over a Drag-Along Sale, including covenanting not to assert fiduciary duty claims (the “Covenant”).
After an opportunity to sell the company materialized, a Drag-Along Sale was negotiated, and the transactions closed. The plaintiffs then filed the present lawsuit. At issue in the suit are fiduciary duty claims challenging the Drag-Along Sale. The defendants moved to dismiss under Rule 12(b)(6) and argued that these claims must be dismissed in light of the Covenant. The plaintiffs countered by arguing that the Covenant is facially invalid.
The Court went to great lengths to tackle these arguments in a 129-page opinion. Having first determined that corporate fiduciary duties are “not immutable,” the Court then turned to an analysis of the “contractarian nature” of Delaware corporate law. The Court concluded that a “close analysis of the DGCL shows that through a private agreement, stockholders can agree to more constraints on their ability to exercise stockholder-level rights than corporate planners can impose through the charter or bylaws.” The Covenant in this case was a such a “stockholder-level agreement and concerns a stockholder-level right.” However, the Court explicitly noted that such “stockholder-level agreement only binds its signatories and only affects how they exercise their rights.”
The Court next addressed whether the Covenant should be invalidated on public policy grounds. The Court declined to do so, rejecting several public policy arguments, including: that the duty of loyalty is “too big to waive”, that the Covenant conflicts with “Delaware’s corporate brand” that “promises standardized terms” such as “the immutable duty of loyalty”; and that provisions like the Covenant collapse the distinction between a corporation and an LLC (the latter which permits the elimination and limitation of fiduciary duties).
After considering a series of factors, the Court held that the Covenant was not facially invalid. The Court reasoned that “[t]his case provides an optimal scenario for enforcement.” The Court explained how the Covenant was located in a Voting Agreement among stockholders (not a charter or bylaw); the provision was clear and specific; the plaintiff funds were sophisticated repeat players who understood the Covenant’s implications (including one being a member of the National Venture Capital Association where the relevant provision appears in that organization’s model agreement); the Covenant was a bargained-for exchange; and, if the plaintiff funds did not like the terms of the Voting Agreement and its Covenant, they could have blocked the Recapitalization, sought different terms, or funded the company themselves. The Court concluded that its decision does not mean that Delaware courts will enforce similar provisions in other cases, but that courts should undertake a similar review of covenants not to sue.
Finally, however, while the Court held that the Covenant was not facially invalid, the Court nonetheless determined that the scope of the Covenant exceeded the limits of Delaware law—namely, that even under Delaware corporate law, intentional harms cannot be exculpated. The Court explained: “The Covenant purports to bar all challenges to the Drag-Along Sale. It cannot insulate the defendants from tort liability based on intentional wrongdoing, but it can protect against other claims.” Since the complaint in this case alleged facts that create a reasonable inference that the defendants could have acted intentionally and in bad faith to benefit themselves and harm the common stockholders leading up to the Drag-Along Sale, the Court declined to dismiss on the basis of the Covenant.