The Delaware Court of Chancery recently issued an opinion in West Palm Beach Firefighters’ Pension Fund v. Moelis & Co. which invalidated provisions of a stockholder agreement that gave broad pre-approval rights over corporate actions. This opinion is important because it demonstrates the allocation of board authority under Section 141(a) of the Delaware General Corporation Law and that contractual agreements may not “improperly constrain a board’s authority.” 

Background 

The agreement at issue was entered into by Moelis & Company (the Company) and its founder (who was also the CEO and then-controlling stockholder) the day before the Company’s initial public offering. The agreement provided certain rights to the Company's founder, including:

• Pre-approval requirements which required prior written consent of the founder before the Board of Directors (the Board) could authorize 18 different types of actions, including: (i) the issuing common and preferred stock or adopting a stockholder rights plan; (ii) incurring of debt above a specified amount; (iii) removing or appointing certain officers (including its founder/CEO); (iv) approving the annual budget; (v) declaring dividends; and (vi) entering material contracts.
• Board composition provisions, giving the founder a variety of rights including:
  1. Requiring the Company to use its best efforts to set the size of the Board to no more than 11 directors.
  2. Requiring the Board recommend that stockholders vote in favor of the founder’s nominees.
  3. A “Vacancy Requirement” which required the Board to fill a vacancy of a designee with a new designee of the founder.
  4. A “Committee Composition Provision” which mandated the Board include a certain number of the founder’s designees on each Board committee.

Stockholders sued and challenged the validity of the foregoing provisions under Section 141(a), arguing that the provisions improperly restricted director authority.

Analysis

The Court of Chancery issued a thoughtful, 133-page decision in which the Court surveyed Section 141 case law dating back decades to yield guiding principles for Delaware corporations.  

First, the court identified a number of factors to help distinguish internal governance arrangements from external commercial arrangements. These include whether the provisions: (i) have a statutory grounding in the DGCL; (ii) are agreed by intra-corporate actors; (iii) encompass how intra-corporate actors exercise corporate power; or (iv) reflect “an underlying commercial exchange” (i.e., consideration).

If the provision is found to be part of an internal governance arrangement, the challenged provision must be evaluated pursuant to the Abercrombie test, which asks whether the provision “[has] the effect of removing from [the] directors in a very substantial way their duty to use their own best judgment on management matters” or “tends to limit in a substantial way the freedom of director decisions on matters of management policy.”

The Court held that the provisions in the agreement were facially invalid because they violated the Abercrombie test by removing the directors' ability to exercise their judgment freely and in the best interests of the stockholders. 

However, the court explained that the Company could likely have achieved a similar result by using its authority to issue preferred stock and granting that preferred stock governance rights. Pointing to Section 141(a), the court noted that corporations are managed by the board “except as may be otherwise provided in this chapter or in its certificate of incorporation.”