Delaware corporate law is renowned for its balance between flexibility in business arrangements and the fundamental principles of fiduciary accountability. One of the areas where this balance is most evident is in the treatment of fiduciary duties and their modification through stockholder agreements. These agreements enable shareholders to manage their rights and obligations within a corporation while still operating within the parameters of Delaware law.
The natural inquiry, then, is “how far is too far?” or “what agreements are enforceable?” The Delaware Court of Chancery addressed these questions in New Enterprise Associates 14, L.P. v. Rich, C.A. No. 2022-0406-JTL (Del. Ch. May 2, 2023) (Laster, V.C.), where it upheld a covenant not to sue in a drag-along provision. The court found the provision was narrowly tailored, clearly written, negotiated among sophisticated parties, negotiable at the time the agreement was made, and part of a “bargained-for exchange.” Id. at 589-90. However, it refused to extend the covenant to claims involving intentional misconduct, reinforcing the notion that Delaware law does not allow private agreements to shield fiduciaries from liability for bad faith. Id. at 591-93.
Stockholder Agreements and Their Role
Stockholder agreements are private contracts among shareholders or between shareholders and the corporation that govern specific rights, obligations, and operational structures. These agreements often are negotiated among sophisticated parties and are crafted with the aim of reducing conflicts and enhancing operational efficiency within the company. Delaware law generally respects such agreements, provided they meet three specific criteria:
- Explicit Terms: The terms of the agreement must be clear and unambiguous, leaving no room for confusion. Id. at 589.
- Voluntary Negotiation: The agreement must be entered into knowingly and voluntarily, particularly in cases involving sophisticated parties like venture capitalists or institutional investors. Id. at 589-90.
- Compliance with Public Policy: The agreement cannot contravene the public policy of Delaware corporate law or statutory mandates. Id. at 591-93.
While stockholder agreements can vary widely, depending on the needs and structure of the company, they often include provisions on:
- Voting Arrangements: These provisions specify how shareholders will vote on certain matters, potentially bypassing the usual voting mechanisms in the company’s charter or bylaws.
- Information Rights: Shareholders may be granted rights to specific financial or operational information from the company.
- Transfer Restrictions: These restrictions can limit a shareholder’s ability to sell or transfer their shares under certain conditions.
- Drag-Along Rights: This provision allows majority shareholders to compel minority shareholders to sell their shares in a company sale, streamlining the sale process.
- Fiduciary Duty Tailoring: Particularly in private equity and venture capital, these agreements may include clauses that limit fiduciary claims, often by including covenants not to sue.
Waivable vs. Non-Waivable Fiduciary Duties
Delaware law recognizes that some fiduciary duties may be modified or waived through stockholder agreements, providing companies with greater flexibility in managing their internal affairs. However, Delaware imposes limitations to preserve core principles of corporate governance.
Waivable Duties
- Corporate Opportunity Doctrine: Under Section 122(17) of the Delaware General Corporation Law (DGCL), directors and officers may waive the corporate opportunity doctrine. This allows them to pursue business opportunities without offering them to the corporation, a critical flexibility in complex corporate structures and relationships.
- Duty of Loyalty: Certain aspects of the duty of loyalty, particularly those related to conflicts of interest, may be tailored through stockholder agreements. For example, drag-along rights often include waivers of fiduciary claims, allowing transactions to proceed without the risk of litigation. New Enterprise Associates 14, L.P.,C.A. No. 2022-0406-JTL.
- Duty of Care: Stockholder agreements also may limit the monetary liability associated with breaches of the duty of care. However, Delaware law distinguishes between direct and derivative claims in this regard. While direct claims for breaches of the duty of care can be waived, derivative claims — those involving the corporation itself — cannot be easily negated. Id. at 549.
Non-Waivable Duties
While Delaware law permits the modification of certain fiduciary duties, there are critical areas where fiduciary obligations cannot be waived, as they are essential to maintaining trust and accountability in corporate governance:
- Bad Faith and Intentional Misconduct: Fiduciaries cannot contract out of liability for bad faith or intentional wrongdoing. Delaware courts have consistently held that these breaches of duty are so serious that they cannot be shielded by private agreements. Id. at 591-93.
- Duty of Oversight: Under Delaware law, directors are responsible for overseeing the corporation’s activities and ensuring the company complies with legal requirements. Claims related to gross neglect of fiduciary oversight, such as those arising from Caremark duties, remain actionable even if other fiduciary duties are waived. See In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959, 970 (Del. Ch. 1996).
The Role of Covenants Not to Sue
A common mechanism for modifying fiduciary duties within stockholder agreements is the inclusion of covenants not to sue. These provisions prohibit stockholders from bringing claims against fiduciaries under certain circumstances, streamlining the resolution of potential disputes. However, for such covenants to be enforceable, Delaware courts impose several requirements:
- Specificity: The covenant must be narrowly tailored, applying only to specific transactions or actions to avoid overreach. New Enterprise Associates 14, L.P.,C.A. No. 2022-0406-JTL, at 589.
- Reasonableness: Courts evaluate whether the parties to the agreement were sufficiently sophisticated, whether they had legal counsel, and whether the covenant respects Delaware’s fundamental principles of corporate governance. Id. at 589-90.
Balancing Flexibility and Accountability
Delaware’s approach to stockholder agreements reflects its broader commitment to balancing flexibility with accountability. While these agreements offer valuable tools for aligning fiduciary duties with business objectives, Delaware law remains steadfast in ensuring certain fiduciary principles are upheld. Stockholder agreements can:
- Tailor Fiduciary Duties: They provide parties with the flexibility to define and limit fiduciary responsibilities, aligning them with business objectives. This is especially important in venture capital and private equity contexts, where companies may wish to streamline governance and reduce the risk of litigation.
- Clarify Stockholder Rights: While the DGCL permits stockholder agreements to determine stockholder rights, it makes clear that these agreements cannot override provisions in the corporate charter or bylaws. Delaware courts have ruled that any provision in a stockholder agreement that conflicts with the corporate charter or the DGCL is ineffective. In W. Palm Beach Firefighters’ Pension Fund v. Moelis & Co., C.A. No. 2023-0309-JTL (Del. Ch. Feb. 23, 2024), the court emphasized that any attempt to alter the governance structure mandated by the DGCL or corporate charter is void.
- Ensure Judicial Oversight: Delaware courts rigorously review stockholder agreements to ensure they do not undermine public policy or statutory protections. While these agreements are respected, courts remain vigilant in ensuring their enforcement does not lead to outcomes that would undermine the integrity of corporate governance.
Conclusion
Delaware law allows for a dynamic approach to corporate governance, balancing the need for flexibility with the necessity of maintaining fiduciary responsibility. Stockholder agreements, when carefully crafted, offer a useful framework for resolving disputes and establishing clear governance structures. However, the law’s safeguards against the waiver of non-waivable fiduciary duties, like the duty of oversight and prohibitions against bad faith conduct, ensure that the integrity of corporate governance is preserved. In this way, Delaware remains committed to fostering innovation in business practices while ensuring trust and accountability remain at the heart of corporate operations.
If you have questions about this article, contact the authors or your Foley & Lardner attorney.
