On February 23, 2024, the Delaware Court of Chancery issued its decision in West Palm Beach Firefighters’ Pension Fund v. Moelis & Company, which invalidated a stockholder agreement between Moelis & Company (the “Company”) and its founder and controlling shareholder, Ken Moelis.[1] The decision generated immediate criticism from members of the Delaware bar, who described it as having “shaken up the existing state of the governance and management of Delaware corporations.”[2] In short, in connection with the company’s IPO, the board of the Company effectively agreed to delegate to Ken Moelis virtually all of the rights and powers traditionally reserved for a corporate board, leaving the board, in the court’s words, in an “advisory” status.

In response, the Corporation Law Council of the Delaware State Bar Association drafted a proposed amendment creating § 122(18) of the Delaware General Corporation Law (the “Proposal”). The Proposal was part of a package of amendments submitted to the Delaware legislature on May 23, 2024. If the legislature adopts the Proposal, the Moelis decision will be reversed in its entirety less than six months after the opinion was issued and prior to any Delaware Supreme Court review.

The Proposal is broadly written. It goes well beyond the Moelis decision and purports to authorize virtually any provision in a stockholder agreement unless such a provision is explicitly prohibited elsewhere in the statute. Most significantly, the Proposal authorizes contractual limitations on both the power of the board of directors and the exercise of the board’s statutorily granted discretion. As such, the Proposal threatens to supplant the board-centric model fundamental to Delaware’s corporate law with a model that allocates fundamental decision-making authority to controllers, activists, or any other stockholders who are able to exert sufficient leverage to extract such authority pursuant to a stockholder agreement.

By implementing unlimited contractual freedom, the Proposal also jeopardizes the longstanding distinction between mandatory and default rules in Delaware corporate law. Although Delaware embraces contractual flexibility, a corporation’s power to modify the basic corporate structure and rights and obligations conferred by the statute has been subject to longstanding limits – the so-called mandatory features of corporate law.  Any reconsideration of principles about the structure of a corporation and the function of a corporate board — including the appropriate scope of the board’s statutory authority and the permissible limits on contractual freedom – should entail a careful weighing of the costs and benefits of a potentially dramatic change. The legislature should also assess whether the quality of Delaware incorporation, a product that a majority of corporations choose by incorporating in the state, will be reduced.

The Moelis Decision

The Company, an investment bank, went public through an initial public offering. One day before the IPO, Ken Moelis, three of his affiliates, and the Company entered into a stockholder agreement which was fully disclosed to the Company’s investors in the IPO documents. The stockholder agreement granted the founder, directly and indirectly, extensive rights related to the management and governance of the Company. In Moelis, the court described these rights as the Pre-Approval Requirements, Board Composition Provisions, and Committee Composition Provisions. Together these provisions gave Ken Moelis either prior approval or veto rights over virtually every meaningful decision the Company’s board would be expected to make.

The plaintiff, a stockholder of the Company, argued that these provisions violated Sections 141(a) and 141(c) of the DGCL. The plaintiff’s claim relied on Delaware precedent holding that governance restrictions in an agreement (as opposed to the corporation’s certificate of incorporation) are invalid if they either directly or indirectly “remove from directors in a very substantial way their duty to use their own best judgment on management matters” or “substantially limit the freedom of director decisions on matters of management policy.” In layman’s terms, while corporations can plainly bind themselves to a broad range of commitments, including to investors and third parties, certain decisions or actions are so central to the fundamental role of a corporate board that directors cannot delegate, abdicate, or transfer those responsibilities.

The Court of Chancery found that some but not all of the provisions in the agreement were facially invalid. It concluded that the Pre-Approval Requirements impermissibly provided for the business and affairs of the corporation to be managed by Ken Moelis, instead of remaining under the direction of the board, and, as such, were inconsistent with DGCL § 141(a). It held that three of the Board Composition Provisions similarly violated DGCL § 141(a). And it determined that the Committee Composition Provision violated both § 141(a) and § 141(c) because determining the composition of board committees falls within the board’s statutory authority. The court upheld provisions granting Moelis the authority to recommend director candidates and to nominate director candidates as well as a provision requiring the Company “to facilitate the election and continued service of Moelis’ designees.”

The court’s decision rested on two distinct grounds. First, it held that the stockholder agreement extended beyond the permissible scope of such agreements and contained restrictions on the board’s authority that are only valid if implemented through a charter provision, which must be approved by stockholders holding a majority of the company’s voting power. Second, the court observed that some restrictions on board authority can be invalid even if contained in the charter, stating that “Even a charter provision cannot override a mandatory feature of the DGCL.” Because none of the provisions in the case at bar was contained in the Company’s charter, the court left the latter question for another day.

The Council’s Response

The Council of the Corporation Law Section of the Delaware State Bar Association acted quickly in response to Moelis. On March 28, 2024, it released a set of proposed amendments to the DGCL. The provision in the amendments addressed to Moelis is new DGCL § 122(18), which would broadly authorize corporations to enter into contracts with stockholders in which a corporation agrees to take or restrict itself from taking actions specified in the contract, “[n]otwithstanding § 141(a).” The proposed amendments, if adopted in the current legislative session, would go into effect on August 1, 2024.

The Bar’s rationale for the Proposal is that it would “fix” the uncertainty created by Moelis.[3] Claims that the decision has created an imminent crisis, however, are likely overstated. It is unclear that many corporations have stockholder agreements as aggressive as the one at issue in Moelis or that provisions commonly found in stockholder agreements cannot be implemented through other means. Additionally, there is no evidence suggesting that Moelis will lead to market instability or cause corporations to relocate outside of Delaware.[4]

Neither the Proposal nor the synopsis offered by the state bar council addresses the fundamental policy considerations raised in Moelis about the appropriate scope of shareholder agreements. Nor does either explore the extent to which public policy or the DGCL contains mandatory provisions that may not be avoided, altered, or overturned through private ordering, whether that private ordering is contained in a charter provision or a stockholder agreement.[5] Both aspects of the decision warrant more careful consideration.

The first issue concerns the appropriate role of stockholder agreements in corporate governance. Commentators have observed that stockholder agreements lack both the transparency of charter provisions and the formal process by which charter provisions are adopted and amended requiring both board and shareholder approval. These approval features provide important protection for the interests of all corporate stockholders. This protection is particularly valuable in private companies in which minority stockholders may have little or no access to critical governance features if those are contained in stockholder agreements and may, as a result, have little understanding of their peers’ rights and responsibilities, the existence of conflicts of interests and, as a result, the company’s risk exposure.[6]

The second issue is the extent to which private ordering may be used to modify mandatory provisions of Delaware corporate law. Simply put, even if a governance mechanism is contained in a charter provision, not every firm-specific charter provision is valid. The Delaware Supreme Court recognized the existence of mandatory features of corporate law in its 2021 Manti decision when it stated: “As a matter of public policy, there are certain fundamental features of a corporation that are essential to that entity’s identity and cannot be waived.”[7] Although Delaware’s alternative entity statutes implement a policy maximizing freedom of contract, commentators have recognized that there are costs as well as benefits to this contractual freedom. A current and a former Delaware judge have written, for example, that “when investors try to evaluate contract terms, the expansive contractual freedom authorized by the alternative entity statutes hampers rather than helps.”[8] One such feature that the courts have continually viewed as mandatory is the board’s authority to manage the corporation, as reflected in DGCL § 141. This authority is central to Delaware’s director-primacy model of corporate law, and commentators have broadly defended this model as critical to the success of Delaware law.

Determining which governance provisions belong in the charter and which are appropriately addressed through shareholder agreements is a difficult question. In Moelis, the Court of Chancery engaged with this question and provided a thoughtful analysis. The Delaware Supreme Court may draw the line differently. Commentators too may reasonably disagree on which features of Delaware corporate law should be mandatory.

The point, however, is that these are questions with which the Proposal does not engage and that warrant further and more careful scrutiny. That analysis would be improved with the benefit of state Supreme Court review of Moelis. Delaware has long been a preferred jurisdiction for incorporation due to its well-established and predictable corporate law framework. Rushed legislative changes that disrupt this stability and that do not give these issues the attention they deserve could erode Delaware’s competitive advantage.

ENDNOTES

[1] W. Palm Beach Firefighters’ Pension Fund v. Moelis & Co., 311 A.3d 809 (Del. Ch. 2024).

[2] Alina M. Yasis, Moelis Decision Shakes Up Governance and Management of Delaware Corporations, Taft, May 13, 2024, https://www.taftlaw.com/news-events/law-bulletins/moelis-decision-shakes-up-governance-and-management-of-delaware-corporations/.

[3] Thomas W. Christopher, Francis E. Lupinacci, Dr. Kathrin Schwesinger & Nasir Tak, The Delaware General Assembly to the Rescue: Proposed Legislative Fixes to Uncertainty Created by Three Significant Delaware Chancery Court Decisions, White & Case, Apr. 15, 2024, https://www.whitecase.com/insight-alert/delaware-general-assembly-rescue-proposed-legislative-fixes-uncertainty-created-three.

[4] To the contrary,  an increasing number of companies, including large privately held unicorn firms, are gravitating towards Delaware. See Anat Alon-Beck, Incorporating Unicorns: An Empirical Analysis, Houston L. Rev. (Forthcoming 2024) (examining  corporate charters within a selected sample of unicorn firms and finding that  97% of these entities are incorporated in Delaware.).

[5] See Jill Fisch, Stealth Governance: Shareholder Agreements and Private Ordering, 99 Wash. U. L. Rev. 913 (2022) (exploring the tension between shareholder agreements and the mandatory features of corporate law).

[6] See Anat Alon-Beck, Bargaining Inequality: Employee Golden Handcuffs and Asymmetric Information, 81 Md. L. Rev., 1165 (2021).

[7] Manti Holdings, LLC v. Authentix Acquisition Co., 261 A.3d 1199, 1201 (2021).

[8] Leo E. Strine, Jr. & J. Travis Laster, The siren song of unlimited contractual freedom, Research Handbook on Partnerships, LLCs and Alternative Forms of Business Organizations, 12 (Robert W. Hillman & Mark J. Loewenstein, eds. 2015).

This post comes to us from professors Jill E. Fisch at the University of Pennsylvania Law School and Anat Alon-Beck at Case Western University School of Law.