CURRENT MONTH (May 2023)
Court of Chancery Denies Motion to Dismiss Based on Covenant Not to Sue for Breach of Fiduciary Duty, but Holds Contractual Limitations on Fiduciary Duties Are Not Facially Invalid under Delaware Law
New Enterprise Associates 14, L.P. v. Rich, C.A. No. 2022-0406-JTL (Del. Ch. May 2, 2023) (Laster, V.C.)
By Pamela Millard, Potter Anderson & Corroon LLP
In an epic opinion analyzing matters of trust and principal-agency law, relevant provisions of the Delaware General Corporation Law (the “DGCL”), and Delaware case law, Vice Chancellor J. Travis Laster concluded that the fiduciary duties of Delaware directors are not “immutable,” and may be “tailored, even without statutory authorization.”
Plaintiffs in the case were investment funds managed by sophisticated venture capital firms that invested in Fugue, Inc., (the “Company”), a startup that failed to achieve either a liquidity event or an exit event for plaintiffs through a third-party sale.
After plaintiffs declined to invest additional funds in the Company, management pursued a new equity infusion from an investor group (the “Investor Group”) led by George Rich (“Rich”), who demanded that (1) the existing preferred stock of the Company convert into common stock, (2) Rich and the Investor Group receive a new class of preferred stock with rights superior to plaintiffs, and (3) plaintiffs and certain existing investors entered into a voting agreement (the “Voting Agreement”). The Voting Agreement contained a drag-along provision with a covenant stating that plaintiffs would not sue Rich or the Investor Group in connection with a drag-along sale, including by asserting breach of fiduciary duty claims (the “Covenant”).
Following the reconstitution of the Company’s board of directors (the “Board”) to include Rich, a second director appointed by the Investor Group, and the Company’s CEO, the Board approved a follow-on recapitalization (the “Recapitalization”), and within months, the Board decided to sell the Company in a transaction representing a drag-along sale (the “Drag-Along Sale”) under the terms of the Voting Agreement. When plaintiffs refused to consent to the Drag-Along Sale after Rich and the Investor Group declined to confirm that they had not engaged in discussions with the potential buyer prior to the Recapitalization, plaintiffs filed a breach of fiduciary duty claim against the Company’s directors. The directors moved to dismiss, claiming that the Covenant constituted a binding contractual agreement that barred plaintiffs from bringing breach of fiduciary duty claims against the Board.
The Court first determined that fiduciary relationships between a trustee and beneficiary as well as agent and principal provide opportunities for “fiduciary tailoring,” and that the DGCL permits private ordering to establish the fiduciary relationship between the directors and the corporation through a purpose clause. The Court noted further that “[t]he DGCL also allows more space for fiduciary tailoring and greater limits on fiduciary accountability than is widely understood,” and clarified that Delaware common law “goes further,” including with respect to the type of contractual restriction contemplated by the Covenant.
Noting that its analysis confirmed that the Covenant is not “out of bounds as a form of fiduciary tailoring,” the Court should then determine whether Delaware law could decline to uphold similar contractual provisions in the interest of public policy. Relying on the Delaware Supreme Court’s opinion in Manti Holdings, LLC v. Authentix Acquisition Co., which held that stockholders could waive statutory appraisal rights by contract, the Court held that similar provisions should be analyzed utilizing a two-part test derived from Manti:
- First, the provision must be narrowly tailored to address a specific transaction that otherwise would constitute a breach of fiduciary duty. The level of specificity must compare favorably with what would pass muster for advance authorization in a trust or agency agreement, advance renunciation of a corporate opportunity under Section 122(17) of the DGCL, or advance ratification of an interested transaction like self-interested director compensation. If the provision is not sufficiently specific, then it is facially invalid.
- Second, the provision must survive close scrutiny for reasonableness. In this case, many of the non-exclusive factors suggested in Manti point to the provision being reasonable. Those factors include (1) a written contract formed through actual consent, (2) a clear provision, (3) knowledgeable stockholders who understood the provision’s implications, and (4) the presence of bargained-for consideration.
The Court concluded that the Covenant met the first requirement of the two-part test since the Covenant was narrowly tailored to a specific event, as well as the reasonableness requirement given the sophistication of the parties involved and plaintiffs’ ability to block the Recapitalization, force the Company to seek different terms, or agree to invest additional funds. The Court also cited principles of Delaware contract law declining to alter the parties’ bargained-for agreement after the fact since the Covenant served as an inducement for Rich and the Investor Group to invest in the Company.
In addition, the Court distinguished limitations on director fiduciary duties contained in a corporation’s certificate of incorporation or bylaws and limitations contained in a stockholder-level agreement, finding that plaintiffs’ “absolutist framing pays no heed to the importance of private ordering,” another fundamental underpinning of Delaware law.
The Court further cabined the broad enforceability of similar covenants, noting that “[a] broad waiver of any ability to assert claims for breach of fiduciary duty would be a non-starter. Even a narrowly tailored provision would likely be unreasonable if it appeared in an agreement that purported to restrict the rights of retail stockholders.”
Having determined that the Covenant “operates permissibly within the space for fiduciary tailoring that Delaware corporate law provides, particularly in a stockholder-level agreement that only addresses stockholder-level rights,” the Court nonetheless applied a public policy limitation, reiterating that a contract governed by Delaware law cannot exempt a party to the contract from tort liability for intentional or reckless misconduct, including claims made by plaintiffs that the directors breached their fiduciary duties by acting in bad faith in connection with the Recapitalization and the Drag-Along Sale.