Delaware’s Recent Governance Reforms: Seawall or Changing Tides?

Last year, the Delaware legislature enacted a significant change to the Delaware General Corporate Law (“DGCL”).  Ordinarily, this development would not get much notice.  Amendments to the DGCL and business entity laws are presented to the Delaware General Assembly by the Delaware State Bar Association’s Corporation Law Council (the “Council”) every year.  These amendments usually entail technical, minor changes to the DGCL.  This time, however, the amendments were anything but technical.  The Council proposed, the legislature passed, and the governor signed into law, the addition of three statutes and the amendment of two more.  The bar is abuzz regarding the controversial addition of DGCL Section 122(18).  The other additions and amendments are viewed as welcome clarifications and changes.  Regardless of their reception, however, these amendments could (and likely will) have widespread ramifications on how Delaware companies conduct themselves in the future.

New Statutory Authorization for Stockholders’ Agreements (DGCL § 122(18))

            Stockholders’ agreements are not new.  They are a mechanism often used to vest a corporation’s stockholders or the beneficial owners of its stock with certain contractual rights for so long as they continue to own specified amounts of the corporation’s stock.

            Recently, however, the Court of Chancery refused to enforce one such stockholder agreement.  In West Palm Beach Firefighters’ Pension Fund v. Moelis & Co., C.A. No. 2023-0309-JTL (Del. Ch. Feb. 23, 2024), Vice Chancellor Laster struck down a stockholder agreement that Ken Moelis reached with Moelis & Co. when he took it public, and which allowed him functionally to remain in control of the business even when his voting stake dropped below a majority.  Vice Chancellor Laster held the arrangement violated DGCL Section 141(a), which requires that corporations be managed by their boards of directors.

            Vice Chancellor Laster held that every time a corporation enters into any kind of contract, the board of directors’ authority to make decisions is somewhat constrained.  For example, if a company enters into an exclusive supplier contract, then the corporation can only buy from that supplier.  The Court held, however, that there is a limit to how much a board can contract away its power of choice.  Those contracts sit on a sliding scale, Vice Chancellor Laster said, starting with ordinary commercial contracts (clearly permissible) and ending with arrangements that ultimately intrude so far into corporate governance that they leave the realm of the commercial and raise a Section 141(a) issue (clearly not acceptable under the previous DGCL).  Vice Chancellor Laster did observe, however, that it arguably was acceptable to adopt these governance restrictions on the board’s authority in preferred shares, instead of separate contracts.

            In reaction to this decision, the Delaware Assembly passed Section 122(18), which expands significantly on what a stockholder agreement can authorize.  Section 122(18) allows corporations to:

Make contracts with one or more current or prospective stockholders (or one or more beneficial owners of stock), in its or their capacity as such, in exchange for such minimum consideration as determined by the board of directors (which may include inducing stockholders or beneficial owners of stock to take, or refrain from taking, one or more actions).  Without limiting the provisions that may be included in such contracts, the corporation may agree to: (a) restrict or prohibit itself from taking actions specified in the contract, whether or not the taking of such action would require approval of the board of directors under this title, (b) require the approval or consent of one or more persons or bodies before the corporation may take actions specified in the contract (which persons or bodies may include the board of directors or one or more current or future directors, stockholders or beneficial owners of stock of the corporation), and (c) covenant that the corporation or one or more persons or bodies will take, or refrain from taking, actions specified in the contract (which persons or bodies may include the board of directors or one or more current or future directors, stockholders or beneficial owners of stock of the corporation).  With respect to all contracts made under this subsection, the corporation shall be subject to the remedies available under the law governing the contract, including for any failure to perform or comply with its agreements under such contract.

In short, this new section allows companies to do what Moelis (and Section 141) proscribed: give stockholders governance power instead of the company’s board of directors. In conjunction with this amendment, there is also a new change to DGCL §122(5) (changes bolded), which permits a corporation to:

Appoint such officers and agents as the business of the corporation requires and to pay or otherwise provide for them suitable compensation; provided that any contract or other appointment or delegation of authority that empowers an officer or agent to act on behalf of the corporation shall be subject to § 141(a) of this title, to the extent it is applicable.

 

            These changes mark a watershed in Delaware law.  Unlike the previous board-centric model of governance codified in DGCL Section 141, these amendments allow for stockholder agreements to contain the type of governance rights once otherwise reserved for the board of directors, or if delegated, that were previously contained in a corporate charter or in preferred shares.  But, unlike previous limitations concerning the issuance of preferred shares, the Section 122(18) amendments do not seem to place any limits on the rights that can be given to stockholders through contract.

            If a corporation could already enact governance restrictions or delegations through a preferred share issuance, why does the right to assign these obligations through a contract matter?  First, if the company is private, then the stockholder agreement containing these restrictions are private too—they likely are unknown to the public or even other investors. That fact means that managerial control could change hands in relative secrecy.  Second, even in a public company, stockholder agreements may be more easily amended than preferred share terms.  So, in short, these amendments make it easier for companies to pass governance control from the board and hand it to a single stockholder.

            Stockholders and corporations also now have unfettered choice to determine which law applies to determining remedies for breaches of these agreements.  Section 122(18) provides:  “With respect to all contracts made under this subsection, the corporation shall be subject to the remedies available under the law governing the contract.”  That provision adds the possibility that California law, or Maryland law, or any other state law, will determine the remedy.  That determination, in turn, might allow a savvy actor to avoid or necessitate certain remedies. A thoughtful drafter would do well to look to the available remedies in each state before choosing the law of their contract.

            These amendments raise yet more questions: how much authority must a Delaware corporation’s board of directors retain, if any?  Would a stockholder, when given managerial control, owe the exact same fiduciary duties currently assigned to the board?  If yes, how much power would the stockholder need to obtain through contract before it owes those fiduciary duties?  Could further private ordering allow for the stockholder to contract away these fiduciary duties, assuming they bind the stockholder in the first place?  Could a stockholder contract away their contract-given managerial control?  What effect will these stockholder agreements have on the disclosure of “risk factors” in registration statements and other SEC disclosure documents?  We anticipate that the courts will soon address these questions, and many others.

Resurrecting the “Dead Hand” Poison Pill

            Another potential consequence of Section 122(18)’s enactment is the possible return of the “dead hand” poison pill.  Like other poison pills, the job of a dead hand poison pill is to make a hostile takeover prohibitively expensive.  Once a hostile bidder acquires a designated amount of the target company’s shares, the poison pill kicks in, allowing only previously existing stockholders to buy newly issued shares at reduced prices.  The poison pill thus lowers the price of shares, but it saves the company from a takeover.

            Where the dead hand differs from a traditional poison pill, however, is who can exercise the right to buy the newly issued shares.  These pills contain provisions that only permit them to be redeemed by “continuing directors.”  Said differently, if a hostile actor were successful in replacing the board via a proxy contest, then the new board members would lack the power to redeem the pill—leaving that right for the previous directors.  Notably, the Court of Chancery previously invalidated these dead hand pills in Carmody v. Toll Bros., 723 A.2d 1180 (Del. Ch. 1998), on the basis that the adoption of such a provision involved both a violation of Section 141(a) of the DGCL and a breach of the directors’ fiduciary duties. 

            Enter Section 122(18).  Under that amendment, a corporation might be able to contract with a private stockholder to name stockholders (who also happen to be current directors) as responsible for determining whether to redeem the poison pill.  In that same contract, the board could not redeem the pill unless the stockholders/present directors assent.  So, under this agreement, even if the directors are replaced in a proxy contest, their specters will prevent the new board members from acting in a manner they believe is consistent with their fiduciary duties.  Whether the new statutory language will trump, limit, or leave the court’s previous ruling unchanged with respect to the dead hand poison pill remains to be seen.

Enforcing Contractual Limitations on Stockholders

            As yet another possible consequence, Section 122(18) might have opened the door to enforce broad contractual limitations on stockholders generally.  The statute’s language says that “[w]ithout limiting the provisions that may be included in any such contracts, the corporation may agree to . . . covenant that . . . one or more persons or bodies will . . .  refrain from taking actions specified in the contract, (which persons . . . may include . . . one or more current . . . stockholders or beneficial owners of stock of the corporation.”  The language means that the corporation can covenant on behalf of its stockholders to have them take or refrain from taking actions, suggesting that the corporation could bind stockholders to a covenant even if the stockholders were not parties to the agreement.  That language further suggests, then, that stockholders that are not parties to a governance agreement could still be bound by the governance agreement.

            A few questions follow from this reading:  Could stockholders authorize a waiver of information rights (under DGCL Section 220) without being actual parties to the waiver by virtue of Section 122(18)’s language?  Can companies now use internal affairs documents to impose restrictive covenants, with a Delaware choice of law clause, to affect an employment relationship that would otherwise be governed by the law of another state (and thereby avoid Focus Financial Partners, LLC v. Holsopple, 250 A.3d 939 (Del. Ch. 2020), and similar cases holding that Delaware choice of law clauses in such governance documents were invalid)?  Again, these questions have no current answers.

Board Approval and Merger Agreements (DGCL §§ 147, 268, and amended § 232)

            In Sjunde AP-Fonden v. Activision Blizzard, Inc., C.A. No. 2022-1001-KSJM (Del. Ch. Feb. 29, 2024), the Delaware Court of Chancery observed that it was disrupting the “practical realities of negotiating merger agreements” by finding that a board must approve an “essentially complete” version of a merger agreement, rather than a substantially final form.  The Court also noted that proxy notices to stockholders must also contain an “essentially complete” version of such agreement or brief summary thereof.  In response, the Delaware Assembly passed DGCL Sections 147 and 268 and amended DGCL Section 232.

            DGCL Section 147 provides that, where Delaware law expressly requires the board of directors approve or take other action with respect to an agreement, instrument or document, it must be approved in final form or a substantially final form.  The synopsis of the amendment observes that competing interpretations of Section 251(b) were previously addressed in Activision and states that Section 147 is intended to provide clarification by enabling the board of directors to approve or ratify an agreement, instrument or document if the material terms are (i) set forth therein or (ii) determinable through information or materials presented or known by the board of directors.  Section 147 also allows the board of directors to ratify an agreement or document that has to be filed or is referred to in a certificate that has to be filed with the Secretary of State, and such ratification will be deemed to relate back to the time of the original approval, so long as the ratification occurs prior to the effectiveness of such filing.

            The amended DGCL Section 232 introduces a new paragraph (g), providing that documents enclosed with, annexed or appended to a notice given to stockholders are deemed to be included with such notice.  Those documents are incorporated solely for the purposes of satisfying the notice requirements of Title 8 of the DGCL; the certificate of incorporation or the bylaws are not intended to be deemed per se material to stockholders.

            DGCL Section 268(a) lists the necessary board approvals and requirements for a merger agreement (other than a holding company reorganization under DGCL Section 251(g)) that provides that all of the shares of capital stock of the constituent corporation are converted into or exchanged for cash, property, rights or securities.  Specifically, (i) board-approved merger agreements do not need to include any provision relating to the surviving corporation’s certificate of incorporation, (ii) any amendment to the surviving corporation’s certificate of incorporation may be adopted by the board or any other person acting at its direction, and (iii) any changes to the surviving corporation’s certificate of incorporation will not be considered an amendment to the merger agreement.

Lost Premium Damages and Stockholder Representatives (Amended DGCL § 261)

            In Luigi Crispo v. Elon R. Musk, C.A. No 2022-0666-KSJM (Del. Ch. Oct. 31, 2023), the Delaware Court of Chancery called into question the viability of two previously accepted interpretations in defining damages in merger agreements to include lost stockholder premiums, or so-called “Con Ed provisions” (adapted from Consolidated Edison, Inc. v. Northeast Utilities, 426 F. 3d 524 (2d Cir. 2005)).  In response, SB 313 amends DGCL § 261 in two subsections to address expressly the uncertainty created by the Crispo ruling.

            DGCL Section 261(a)(1) clarifies that, through an express provision, parties to a merger or consolidation agreement may enumerate the remedies (including a requirement to pay lost premium damages) of a party’s failure to perform its obligations under the agreement.  Remedies may include payment obligations to the other party if the merger or consolidation is not consummated, such as termination fees, and that the nonbreaching corporation is entitled to retain such payment (so the corporation would not have to distribute the proceeds to its stockholders).

            DGCL Section 261(a)(2) further clarifies that, through an express provision, parties to merger or consolidation agreement can:  (i) appoint a stockholders’ representative of any constituent corporation; (ii) delegate sole and exclusive authority to take action on behalf of the stockholders under that appointment agreement, (iii) make such appointment irrevocable and binding on all stockholders from and after adoption of the agreement by vote of the stockholders, and (iv) agree that the foregoing provisions cannot be amended after the effective date of the merger or consolidation, or may be amended solely by consent or approval of specified persons.  The synopsis further clarifies that the stockholder representative’s authority under Section 261(a)(2) only authorizes the exercise of power to enforce rights under the agreement—and no more.

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            This discussion is not in any way exhaustive, and much about how Section 122(18) will change the Delaware landscape remains unknown.  Quinn Emanuel as should businesses and practitioners—will closely follow further developments in this space.