Under Section 141 of the Delaware General Corporation Law, a corporate board could theoretically create a committee consisting of a single director, call her Daphne, to whom it gives a veto right over all decisions taken by the full board. If that’s the case, shouldn’t it be able to enter into a contract that gives a non-board stockholder, call him Steve, the same veto right, even though, unlike director Daphne, stockholder Steve is not a member of the board?  If not, could the corporation grant the non-board stockholder, Steve, that same veto right through a charter amendment?  I think the best reading of Delaware law would answer both questions in the negative and for good reason.  And yet, the Delaware legislature’s adoption of Section 122(18) just last summer would provide affirmative answers. As I argue in a recent essay, this amendment signals a truly revolutionary understanding of corporate law that is destined to frustrate the corporation’s built-in purpose of fostering long-term capital allocation with the associated economic benefits. There’s a potential solution here, but let’s first consider the background.

The spark that ignited the Section 122 revolution was West Palm Beach Firefighters’ Pension Fun v. Moelis & Co.,[1] a Delaware Chancery opinion that invalidated a stockholder agreement between Ken Moelis and Moelis & Co., the investment banking firm Moelis had founded and with respect to which he served as chairman of the board.  That stockholder agreement gave Moelis a veto right over all board decisions, which a group of stockholders challenged as violating the Section 141(a) requirement that the corporation be managed by the board. In a thoughtful opinion, Vice Chancellor Laster held that the agreement was invalid because it pertained to governance (rather than commercial) matters and removed from directors in a “very substantial way” their duty or freedom to decide.  The response from lawyers to Moelis was both remarkably swift and remarkably critical, especially because it threatened the emerging market practice of Moelis-type stockholder agreements.  In response to the hue and cry, the Delaware General Assembly adopted a new statutory provision, Section 122(18), which authorizes a board to enter into any agreement, including governance-related ones, as long as the contract-based governance provisions could have been adopted in the corporation’s charter.  And then, for the avoidance of doubt, the statute lists a number of specific governance provisions that could be adopted by contract, consistent with the new provision, including Moelis-type veto rights.

As it currently stands, Section 122(18) upends the “perpetual entity” model of the corporation, which, as I have argued, best justifies and fits the caselaw and the structure of corporate fiduciary duties.[2]  Under that perpetual entity model, the corporation is not fundamentally the result of contract but rather the result of a policy decision to create an entity that is uniquely focused on long-term capital allocation.  It does so by creating a decision-maker – the board – that is independent from all stakeholders and  subject to duties that focus attention not on any flesh-and-blood stockholder but on the hypothetical permanent holder of the equity capital.  This model of the corporation explains why fiduciary duties are said to be owed not to the stockholders per se, but to the entity as a whole or, in other words, the permanent aspect of the entity as instantiated in its permanent equity capital. It explains why stockholder voting rights for fundamental transactions seem to exist only at the board’s election since the board can usually design the transaction to either trigger voting rights or not. It explains why stockholders can, in certain circumstances, bring derivative lawsuits but aren’t entitled to any recovery.  In short, the perpetual entity model is, as one Delaware Chancery judge opined in endorsing my analysis, “how Delaware law has traditionally viewed corporations.”[3]

The perpetual entity model of the corporation, and the traditionalist view of corporate law that accompanies it, goes hand in hand with Delaware’s peculiar non-penalty-based approach to law.  That is to say, Delaware courts spend a lot of time carefully developing fiduciary duty law, explaining what the broad-based duties of care and loyalty imply for different contexts.  But they rarely enforce these norms with monetary penalties, and often they make it difficult if not impossible to do so.  (Think of insulating duty of care inquiries with the business judgment rule or reformulating Caremark duties to require the very elevated standard of a “conscious disregard” or Corwin’s eliminating monetary penalties for Revlon violations).

The best explanations for Delaware’s general unwillingness to imposed monetary penalties focus on the special role played by the board.  For example, in one such explanation, Professor Edward Rock focuses on how the board is part of an ecosystem of corporate lawyers and other advisers who communicate Delaware’s under-enforced norms to the board and where compliance is encouraged through informal threats of reputational sanctions.[4]  A complementary theory that I have suggested in a working paper is that Delaware law appears to treat corporate boards as “legal internalizers,” people who comply with the law not out of fear of sanctions but out of an attitude of rule acceptance that motivates compliance.  Perhaps because of their appointment through stockholder elections, directors see their role as requiring compliance with the law.  Or maybe they are boundedly rational actors who view legal compliance as a heuristic that is as good as any other at helping them pursue their self-interest. Regardless, whether board members actually comply with Delaware corporate-law norms because of a threat of informal sanctions (as in Rock’s account) or because they internalize the law (as in mine), the point is that the law would only function properly in such a system if the person making the relevant business decisions were actually a member of the board.

It is these principles – the perpetual entity model’s traditionalist view of Delaware corporate law and Delaware’s board-oriented, non-penalty-based approach to law – that give cause for concern about Section 122(18).  The perpetual entity model implies that there are certain governance arrangements – in particular, those that compromise the board’s fundamental orientation toward long-term capital allocation – that can’t be adopted even in the corporate charter.  And Delaware’s board-centered, non-penalty-based approach to law implies that corporate decision-making power shouldn’t be given to non-board members, at least not without fundamentally rethinking the law.  And yet, Section 122(18) would ostensibly allow for both .

This analysis has implications both for the Moelis opinion itself and for Section 122(18). With respect to Moelis, this analysis suggests an alternative road-not-travelled for the case. One might have interpreted Moelis’ veto right as requiring him to exercise his judgment consistent with a long-term view of capital allocation (he was after all a significant stockholder), essentially extending to him the duties of any other corporate fiduciary. And thus, the only remaining concern would not have been that the veto right departed from the corporation’s inherent focus on long-term capital allocation (the concern of the perpetual entity model) but rather that such discretion was being handed to a non-board member (in violation of Delaware’s board-centered, non-penalty-based approach to law).  And yet, Moelis was in fact a member of the board, the chairman no less. So, the agreement in that particular case didn’t seem to pose the same threat to the traditionalist account of Delaware law that other governance agreements might, and thus one can imagine the case coming out a different way.

But what of those other governance-based agreements, the ones not involving director-counterparties like Moelis? This analysis also says something about them. It suggests that for Section 122(18) to be consistent with the view of Delaware corporate law reviewed here, Moelis-type contracts, and the other governance-related agreements authorized in Section 122(18), must be limited to counterparties who are either board members or controlling stockholders. It’s not too late to amend Section 122(18) accordingly. Doing so would preserve the way Delaware corporate law has historically functioned, retaining its internal logical integrity. It would at the same time forestall the brave new world where the corporation, a regulatory tool for generating long-term economic growth, is at long last the maximally modifiable private technology that until now has been merely the stuff of the corporate contractarian’s dreams.

ENDNOTES

[1] 311 A.3d 809 (Del. Ch. 2024).

[2] Zachary J. Gubler, The Neoclassical View of Corporate Fiduciary Duty Law, 91 U. Chi. L. Rev. 165, 170 (2024).

[3] McRitchie v. Zuckerberg, 315 A.3d 518, 572 (Del. Ch. 2024)

[4] See Edward B. Rock, Saints and Sinners: How Does Delaware Corporate Law Work? 44 UCLA L. Rev. 1009 (1997).

This post comes to us from Professor Zachary Gubler at Arizona State University’s Sandra Day O’Connor College of Law. It is based on his recent article, “The ‘Section 122 Revolution’ in Delaware Corporate Law and What To Do About It,” published in the Cornell Law Review Online and available here.