West Palm Beach Firefighters’ Pension Fund v. Moelis & Company, C.A. No. 2023-0309-JTL (Del. Ch. Feb. 23, 2024) (Laster, V.C.)

In a decision grounded in Delaware corporate governance first principles and with far-reaching implications for the implementation of internal corporate governance arrangements, the Delaware Court of Chancery held that several provisions in a stockholders agreement were facially invalid because they impermissibly restricted the board’s ability to exercise its authority consistent with the requirements of Delaware corporate law. While the Court acknowledged that Delaware law favors private ordering, this decision emphasizes that, if a corporation desires to alter or impose restrictions on the traditional director-centered management structure for a Delaware corporation, it must implement these arrangements in compliance with Section 141(a) of the General Corporation Law of the State of Delaware (the “DGCL”).

Plaintiff in this dispute challenged several provisions in a stockholders agreement that Ken Moelis (“Moelis”), founder, Chief Executive Officer, and Chairman of the Board of Directors of Moelis & Company (the “Company”), his controlled affiliates, and the Company entered into shortly before the Company’s initial public offering. The agreement provided Moelis and his controlled affiliates with substantial governance control over the Company. Specifically, the agreement required that the Board (i) receive Moelis’ prior written consent before undertaking eighteen specified categories of corporate actions, such as incurring debt over certain amounts, issuing preferred stock or issuing equity or equity-related securities over certain amounts, removing or appointing certain officers, entering into or amending material contracts, or amending governance documents (the “Pre-Approval Requirements”), (ii) maintain its size at no more than 11 directors (the “Size Requirement”), (iii) nominate Moelis’ director designees for election to the Board (the “Nomination Requirement”), (iv) recommend that the Company’s stockholders vote in favor of Moelis’ director designees (the “Recommendation Requirement”), (v) fill any vacancy in a Board seat held by a Moelis director designee with a new Moelis director designee (the “Vacancy Requirement”), and (vi) appoint a number of Moelis director designees in proportion to the number of Moelis directors designees on the full Board to each committee of the Board (the “Committee Composition Provision”). The agreement also permitted Moelis to designate directors for a majority of the Board seats (the “Designation Right”) and required that the Company use reasonable efforts to cause Moelis’ designees to be elected to the Board (the “Efforts Requirement”). Plaintiff argued that all of these provisions were facially invalid and unenforceable under Section 141(a) and, in one circumstance (the Committee Compensation Provision), Section 141(c)(2) of the DGCL.

On cross-motions for summary judgment, the Court examined precedent decisions that analyzed facial challenges to the validity of corporate contracts under Section 141(a) of the DGCL.  From these precedents, the Court developed a two-step test that applies when a Delaware court evaluates whether a contractual provision or arrangement impermissibly restricts the Board’s ability to exercise its authority in accordance with Delaware law. Under this framework, a Delaware court must first consider whether a challenged contractual provision “constitutes part of the corporation’s internal governance arrangement.” If not, the Court’s inquiry ceases. If it does, Section 141(a) of the DGCL is implicated and the Court then applies the test set forth in Abercrombie v. Davies, where the provision will be deemed invalid if it has “the effect of removing from 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[.]”

For part one of this test, the decision identified seven factors that a Delaware court should consider when deciding whether a contract is a governance arrangement or a commercial agreement. The Court explained that governance arrangements (i) usually have a statutory hook in the DGCL, (ii) involve counterparties that are likely intra-corporate actors, such as corporate officers, directors, stockholders, or their affiliates, (iii) have terms where “the intra-corporate actors can authorize the corporation’s exercise of its corporate power[,]” (iv) do not involve a clear commercial exchange, (v) have governance rights as the primary focus of the agreement, (vi) are more likely to involve circumstances where the parties will seek equitable relief as opposed to damages for a breach of the agreement, and (vii) usually have a longer duration and are typically more difficult for the corporation to terminate, if at all.

For part two of the test, the decision explained that Delaware courts must assess, as part of the application of the Abercrombie standard, whether the contractual provision that is a part of the corporation’s governance arrangement imposes direct or indirect board-level or corporate-level restrictions. Direct restrictions bind the board, corporation, or individual directors with respect to taking or not taking a specific action, and indirect restrictions impose “a sufficiently onerous consequence” on the board, corporation, or individual directors for taking or not taking a required action.

Applying this two-step test to the provisions at issue, the Court held that all of the provisions challenged by plaintiff were “prototypical governance provisions in a prototypical governance agreement” and, therefore, were “part of the Company’s internal governance arrangement[,]” implicating Section 141(a) of the DGCL and triggering further review. The Court then determined that the Pre-Approval Requirements, as a whole, were direct, board-level restrictions in violation of Section 141(a) of the DGCL and were facially invalid. The Court specifically noted that the Pre-Approval Requirements were “so all-encompassing” that they effectively “render[ed] the Board an advisory body.” The Court also held that the Recommendation Requirement, the Vacancy Requirement, and the Size Requirement were facially invalid for similar reasons and noted that these provisions stripped the Board of its ability to use its “own best judgment.” The Court further determined that the Committee Composition Provision was a direct, board-level restriction in violation of Section 141(a) and Section 141(c)(2) of the DGCL and was facially invalid. However, the Court determined that the Designation Right, the Nomination Requirement, and the Efforts Requirement were not facially invalid under the second step of the test, as those provisions could operate in harmony with Section 141(a) of the DGCL and did not impermissibly restrict the Board’s or Company’s authority.

This decision once again emphasizes Delaware’s board-centric model of corporate governance and serves as a reminder that, while Delaware favors private ordering, engaging in private ordering is subject to the limitations set forth in the DGCL.

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