The Board Rules Delaware: Delaware Chancery Court Curtails Founder's Control Over Board of Directors

by Amandeep S. Cheema, Esq. (Pasricha & Patel, LLC)

“The DGCL governs the internal affairs of corporations, which are a reified form of autonomous property that exists by virtue of Delaware exercising its sovereign authority.”

The preeminent authority of the Board of Directors of a Delaware corporation (the “Board”) is statutorily conferred by Section 141(a) of the Delaware General Corporation Law (the “DGCL”), which dictates that “the business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation.”

But what if a stockholder agreement (also known as a shareholders’ agreement), duly executed by all the shareholders of the Delaware corporation, decrees an alternative method or hierarchy of corporate management? What if the alternative method diminishes the authority of the Board and allows for the founder of the corporation to override Board decisions without much resistance? What if the certificate of incorporation authorizes the alternative method of management and such method effectively undermines the authority of the Board? In its recent opinion on West Palm Beach Firefighters’ Pension v. Moelis & Co., (“Moelis”) the Delaware Chancery Court (the “Court”) provides some direction.

In Moelis, the stockholder agreement in question requires the Board of a Delaware corporation to obtain the consent of Ken Moelis, the founder, CEO, and chairman of the Board, prior to taking one of many categories of action. The stockholder agreement further grants the founder the right to handpick a majority of the members of the Board, regardless of whether the founder holds a majority of the corporation’s outstanding voting power at the time of Board election. The plaintiff in Moelis is a stockholder in the corporation and argues that the veto and Board selection rights granted to the founder through the stockholder agreement are in violation of Section 141(a). The Court determines that the veto rights are in violation of Section 141(a), while the Board selection rights are not.

The Court provides us with a two-part test to determine whether challenged provisions of a stockholder agreement are in fact in violation of Section 141(a) of the DGCL.

1. Internal Governance Agreement. First, we must determine whether Section 141(a) applies to a challenged provision. If the challenged provision is part of an internal governance agreement, then it is subject to Section 141(a). External commercial contracts that seek to implement internal restrictions shall also be subject to Section 141(a). The Court suggests an analysis of the following factors to determine if a document is an internal governance agreement:
   • Governance agreements frequently have a statutory grounding in a section of the DGCL. For example, stockholder agreements are based in Section 218(c) and (d) of the DGCL;
   • The corporation’s counterparties in a governance agreement are intra-corporate actors (i.e. shareholders);
   • The challenged provisions seek to specify the terms on which intra-corporate actors can authorize the corporation’s exercise of its corporate power;
   • The governance agreement does not readily reveal an underlying commercial exchange;
   • The relationship between the contractual restrictions and a commercial purpose (i.e. is the primary purpose of the document to protect the bargain, or to protect the governance arrangement?);
   • The presumptive remedy for breach (i.e. damages vs. equitable relief enforcing a right); and
   • The ease at which the corporation may terminate the agreement (governance agreements are generally more difficult to terminate).

   If the document containing the challenged provisions is determined to be an internal governance agreement in accordance with the above, then we can move to the second part of the analysis—the Abercrombie Test.

2. Abercrombie Test. The Abercrombie Test requires us to determine whether the challenged 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 if the challenged provision “tends to limit in a substantial way the freedom of director decisions on matters of management policy.” If an application of either of the aforementioned metrics is affirmative, then the challenged provision is in violation of Section 141(a).

What is the practical take away from Moelis? First, we must acknowledge that it is quite typical for startup founders and entrepreneurs to safeguard their influence in the corporation’s governance documents, ensuring they maintain authority over members who may be less invested than the founder in the initial stages of a new company. Nevertheless, the Court emphasizes that the DGCL trumps market practice, as “typical” as the market practice may be. “When market practice meets a statute, the statute prevails. Market participants must conform their conduct to legal requirements, not the other way around.”

In light of this decision, founders must be attentive, and at times creative, in drafting their governance documents. Here are a few things founders can implement in the early stages of their Delaware corporation to preserve legitimate control over their company to the extent permitted by law:

1. Incorporate limitations on the Board’s managerial authority into the Certificate of Incorporation.
2. Issue to the founder preferred stock carrying a set of voting rights and/or director appointment rights.
3. Issue non-voting classes of shares to investors and other grantees.