Contracting Out Of Corporate Law: Should Public Company Boards Be Allowed To Delegate Governance To A Single Stockholder?

Activist Settlements and A Proposed Amendment to the DGCL

Perhaps the most fundamental expectation of public company investors is the expectation of investing in a company run by a board of directors – a board elected by stockholders and charged with managing the corporation on behalf of all stockholders. Delaware seems primed to upset that expectation.

A proposed amendment to Section 122 of the Delaware General Corporate Law would allow boards to delegate out (to a greater or lesser extent) their most essential function – that of using their unfettered, independent discretion, filtering and balancing diverse stockholder voices and interests, to steer management in the direction most beneficial to stockholders as a whole. The proposed amendment would allow the board – without subjecting its decision to the rigors of a stockholder vote – to grant to third parties very significant governance rights, including veto rights, board seats and control of board committees in exchange for "such minimum consideration as determined by the board of directors."¹ These third parties will not be constrained by fiduciary duties in exercising any such veto rights, and it can be expected that their designees for board and committee seats will in many cases be "dual fiduciaries" – employees or partners of the stockholder that designated them – meaning that these designees will owe duties both to their employer and to the company's stockholders generally. As discussed below, these duties are unlikely to be reliably compatible.

The Moelis Case and Proposed Amendment

The proposed amendment comes as a direct response to the Chancery Court ruling in West Palm Beach Firefighters Pension Fund v. Moelis & Company² ("Moelis"). At issue in Moelis was a stockholder agreement granting Mr. Moelis a variety of governance rights, including:

In Vice Chancellor Laster's view, the scope of these rights meant that "the business and affairs of the Company are managed under the direction of [Mr.] Moelis, not the Board"³ resulting in a violation of what had previously seemed a cardinal rule of Delaware corporate law – DGCL 141(a). This core provision of the DGCL requires that "the business and affairs of every corporation . . . shall be managed by or under the direction of a board of directors, except as may be otherwise provided in . . . its certificate of incorporation."

Frankly, given the scope of the rights granted to Mr. Moelis, it would seem extraordinarily difficult to argue with the Vice Chancellor's conclusion. While some stockholder's agreements may edge up to infringement of DGCL 141(a), the Moelis stockholder agreement seemed expressly designed to fully replace the board's judgment on important business decisions with the judgment of Mr. Moelis. Yet in spite of the egregious nature of the breach of DGCL 141(a) (and in spite of the ease with which the breach could have been avoided), there seemed to be some sympathy for the Moelis arrangements. After all, these arrangements were in place at the time of the IPO, so the market must have been sold from the start on Mr. Moelis continuing to run the company more or less in his sole discretion – there was no bait and switch. However, even if you buy the argument that it is ok to neuter the board of a public company so long as that intention is fully disclosed before selling any equity securities, the far more traditional (and enforceable) way to do so is to reflect these governance provisions in the certificate of incorporation. This approach would have assured Mr. Moelis that his rights would be enforceable and would have given stockholders the comfort of knowing that they would get to vote on any amendment of those rights. Had Mr. Moelis decided to exert his control by implementing his control rights in the charter, there would have been no breach, no Moelis ruling, and no proposed amendment of the DGCL. ⁴

So the reason for the startlingly rapid response of the Delaware bar to Moelis must lie elsewhere. Widespread market chatter would indicate that the most immediate concern was not about allowing founders greater control rights after the IPO of their creations, but rather about what the ruling in Moelis would mean for activist settlement agreements. These agreements typically fix a maximum number of directors, require that the board appoint a number of directors at the instruction of the activist (and continue to nominate and recommend the activist's candidates and replacements), and often include a requirement to form a committee⁵ (staffed at least in part with activist candidates) to explore strategic alternatives or other priorities of the activist. Accordingly, these settlement agreements would seem to trigger many of the same breaches of DGCL 141 as the Moelis stockholder agreement.⁶ Given the ubiquity of activist settlements, Moelis – barring adoption of the proposed amendment – would have more far greater consequences for the practice of activism than for founder IPOs. As a result, the focus here is on this one use case (though there are many more goblins in the closet).⁷

Certainly, the bar was not slow to realize the value of the Moelis ruling in challenging activist settlement agreements. Very shortly after the Moelis ruling was published, a complaint was filed in connection with the Crown Castle proxy fight, led by a co-founder of Crown Castle, Theodore B. Miller.⁸ In his complaint, Mr. Miller attacked a settlement agreement Crown Castle had previously entered into with the activist Elliott Investment Management, seeking to invalidate key provisions of the settlement agreement that set the maximum number of board seats, dictated the composition of certain board committees, and required the board to nominate Elliott's designees and recommend their election to stockholders. This attack was based expressly on the Chancery Court's ruling in Moelis. While Mr. Miller also attacked the settlement on the grounds, inter alia, that the directors breached their Unocal duties in approving the settlement (characterizing the settlement as a defensive measure that interfered with the stockholder franchise), a Unocal claim is significantly more complicated to pursue. A claim under Unocal requires an evaluation as to whether there is a threat to corporate policy or effectiveness, and as to whether the settlement is a reasonable and proportionate response to the threat.⁹ A claim under Moelis requires only a showing that certain provisions of the settlement agreement, by conflicting with DGCL 141, are facially invalid.¹⁰ In short, the Moelis ruling created a new and effective threat to a common model of activist settlements.¹¹

Contracting Out of Corporate Law

The proposed amendment, by allowing contract law to override corporate law, would eliminate this threat to activist settlements and, going further, would allow the boards to award governance rights well beyond those included in current activist settlements. The amendment would effect a shift in power from stockholders to the board by allowing the board, without stockholder consent, to contract away the representative governance arrangements enshrined in the charter in order to settle actual or threatened proxy contests.

Corporate law exists to provide a framework for collective action, with fairly uniform voting and representation mechanisms to allow the stockholders, in certain limited circumstances, to decide how, and by whom, their collectively owned enterprise is to be managed. Since it is a near impossibility to have all stockholders in a public company vote unanimously, corporate law and the company's charter establish approval thresholds by which collective action may be taken. The vote binds all stockholders and the corporation. Contract law, by contrast, establishes rights only among the parties to the contract, and provides benefits only to the parties to the contract.

The parties to an activist settlement agreement are typically the company (represented by the board) and the activist. Most commonly, the board bargains away governance rights in exchange for the activist foregoing its right to engage in a proxy fight – in the process eliminating the ability of stockholders to vote on the election of rival candidates. On one side, the bargain will of course benefit the activist. On the other side, while it is possible that this bargain will benefit stockholders, it is also possible that the bargain struck will in some measure benefit the board. Given this context, perhaps the most troubling aspect of the proposed amendment is the provision allowing the board to grant governance rights to a single stockholder "for such minimum consideration as determined by the board." If this phrase is interpreted to obliterate the fiduciary standards by which the board would ordinarily be judged for entering into such an agreement, then the amendment would seem to create a very significant moral hazard for boards faced with an activist threat.¹² If the phrase is not so interpreted, the new legislative license given to boards to contract out of the corporate law framework will at a minimum increase the workload of the Chancery Court, which will be asked repeatedly whether the bargain was struck to benefit the board or to benefit stockholders.

Stockholder Expectations and Unaligned Interests

Stockholders all have different risk appetites, different investment horizons, different buy-in prices and different tax bases, different views on dividends, investments, business combination opportunities and the market generally. So, what is the salutary effect of advantaging one stockholder by handing that stockholder the keys to the boardroom, creating and staffing committees for that stockholder, and now perhaps even granting veto rights to that stockholder?

To understand the issues arising when handing this degree of influence to a single stockholder, one must completely shake off the lingering mists surrounding the always risible idea that all stockholders are aligned in their ultimate interests and that accordingly advantaging one stockholder advantages all stockholders. In fact, this is not even coherent enough to rise to the level of an idea – it is more like a feeling, a haunted notion, that since all stockholders should want to maximize value, all stockholders should want the same thing. Unfortunately, we do not live in that delightful of a world.

State Street may have been the first of the major institutional investors to embed into their stewardship policies an acknowledgement that activists may have different interests than State Street's investors, noting in 2016 "the inherent tension between short-term and long-term investors" and its wariness "of activist models of engagement that favor short-term gains at the expense of long-term investor interests," particularly in the context of activist settlement agreements.¹³ Blackrock's Larry Fink has publicly worried about "incentives to maximize short-term returns at the expense of long-term growth"¹⁴ and about companies "succumb[ing] to short-term pressures to distribute earnings, and, in the process, sacrifice[ing] investments in employee development, innovation, and capital expenditures that are necessary for long-term growth." In particular, Mr. Fink noted the hazard to corporations of succumbing "to activist campaigns that articulate a clearer goal, even if that goal serves only the shortest and narrowest of objectives."¹⁵ In short, our largest institutional investors, with their vast experience, are convinced that short-term investors may well have goals inimical to the interests of long-term investors – that there is no necessary alignment of investors.

In the absence of such alignment, it is hard to understand why Delaware would make it easier for boards to turn over a substantial portion of their governance responsibilities to a single stockholder that owes no duties to its fellow stockholders. Or why Delaware should facilitate a settlement model that often results in the appointment of "dual fiduciaries" who owe duties to an activist as well as to the company. Given the fact that an activist investor may well have pervasively different interests than the remaining stockholders, these dual fiduciaries may in fact be akin to a "constituency directors," representing a constituency of one.

Alternatives to the Current Settlement Model

Let us imagine living in a post – Moelis world – one without the proposed amendment. Settlements of proxy fights would have to follow a different model. The activist and board could agree to appoint new directors. The board could also agree to create committees and include activist representatives in the initial membership of such committees. As is the case today, the board would have to find sufficient justification for awarding these significant rights. The board however would not be allowed to compromise its ability to govern the corporation in the future. It could not allow the activist discretion to replace its board candidates in the future, it could not promise to limit the size of the board, or to recommend the activist's future board candidates to the stockholders. It could not grant veto rights to an activist.¹⁶

One could ask whether a single stockholder should be allowed greater influence than this without a stockholder vote. For some corporate practitioners, it is hard to imagine the corporate law functioning properly in a world where the free exercise of fiduciary responsibilities is materially constrained by prior agreement. For example, consider the case where an activist's candidates are appointed to the board. In the period before those candidates are put up for election, one of these candidates has acted badly or has otherwise failed to convince the other members of the board of his or her value to the corporation. The board should not be required to recommend this candidate to the stockholders. Agreeing in advance to do so puts directors in an impossible position, presenting directors with a dilemma that will seem very close to a Hobson's choice – either properly exercise your fiduciary duties (triggering an immediate ugly lawsuit against the company with the costs and distractions this would entail) or find a way to justify recommending the objectionable candidate (who, regardless of his or her ability to stay awake in meetings, may have an excellent resume, making any breach of fiduciary duties almost invisible). The proposed amendment may make it legal to agree to recommend a director candidate who the majority of the board thinks is incompetent or grossly self-interested, but doing so would be a serious (though very tempting) violation of trust. It simply cannot be an element of good governance to encourage this dynamic.

And that will of course be the focus of the Delaware legislature – whether the amendment promotes good governance – not how successful the amendment is in adapting the law to facilitate current market practice. While the proposed amendment is being modestly sold as providing "greater statutory guidance," allowing the most basic element of corporations law to modified by contract – particularly in the context where the contract is being made between directors whose jobs are threatened and an activist stockholder (in a world where the large majority of stockholders are likely to be long-term investors) – seems like a step that deserves a very significant pause and debate.

Footnotes

1. Delaware State Senate, 152^nd General Assembly, Senate Bill No. 313, An Act to Amend Title 8 of the Delaware Code Relating to the General Corporation Law.

2. West Palm Beach Firefighters' Pension Fund v. Moelis & Company, C.A. No. 2023-0309-JTL (Del. Ch. Feb. 23, 2024).

3. Moelis at p 10.

4. Vice Chancellor Laster noted in his opinion that including governance rights in a certificate of designation for a preferred share is another approach allowing the board to delegate governance rights to third parties. Given the prevalence of authorized blank check preferred, this could be done well after an IPO, raising the same bait and switch problem as the proposed amendment. However, preferred shares are most often issued in connection with a PIPE investment- where new money (often much needed new money) is invested into a public company, and the governance rights granted are viewed as means for the investor to monitor its investment. While some activists have made PIPE investments in target companies, that is still an atypical approach, and one that very clearly puts the activist in a different position from that of other common stockholders (whose votes are needed to give the activist's threats of a proxy contest any weight). Accordingly, preferred shares do not seem like a perfect substitute for the type of stockholder's agreement the proposed amendment would permit.

5. Note that DGCL 141(c) reserves to the board the right to decide whether to form a committee.

6. Note that the court in Moelis briefly discussed the applicability of its analysis to a hypothetical activist settlement agreement. Moelis at p126.

7. These include worries about the resurgence of dead hand poison pills, controllers (post-IPO) granting themselves veto rights and other control rights, and controllers seeking to insulate themselves from liability for breaches of the duty of loyalty. See Marcel Kahan and Edward Rock, Proposed DGCL Section 122(18), Long Term Investors, and the Hollowing Out of DGCL 141(a), May 21, 2024 Harvard Law School Forum on Corporate Governance; Brian JM Quinn's letter to Kate Harmon, President of the Delaware State Bar Assn, April 12, 2024.

8. Similar complaints were brought challenging activist settlements at L3Harris Technologies, Inc. and BioMarin Pharmaceuticals, Inc.

9. Presumably a proxy contest will always present a threat to corporate effectiveness or policy. A court may well find a settlement giving up 2 board seats to be reasonable where the activist is seeking 4 seats, though some might argue that facilitating the implementation of the activist's threat by giving up board seats is not a reasonable reaction to the threat.

10. Moelis did not find that all of the challenged provisions were facially invalid, but the key provisions (veto rights, limits on board size, the requirement to recommend the activist's designees and fill vacancies and committee composition requirements) were found to be facially invalid.

11. While some activists in reaction to Moelis amended their settlement agreements to, among other things, provide a "fiduciary out" allowing directors to refrain from nominating or recommending the activist's designees if it would be contrary to the directors' fiduciary duties, exercising this fiduciary out would terminate the activist's standstill. Accordingly, to exercise its fiduciary duties, the board would trigger the very proxy fight that the settlement was designed to avoid. It is unclear whether a Delaware court would find that the board agreeing to incur a penalty (termination of the standstill) in order to exercise its fiduciary duties would be deemed a significant enough impediment to exercising fiduciary duties as to remove "from directors in a very substantial way their duty to use their own best judgment on management matters." Abercrombie v Davies, 123 A.2d 893, 899 (Del. Ch. 1956). As in the M&A context, the cost to the corporation of exercising the fiduciary out will presumably matter.

12. The phrasing "such minimum consideration as determined by the board" is odd. It would seem to fully justify directors in entering into these agreements so long as the directors could point to some minimum consideration received. There is at least a question as to whether the phrase is intended to give legislative license to override existing fiduciary standards in deciding to enter into an activist settlement agreement.

The synopsis provided with the proposed amendment states that "New Section 122(18) does not relieve any directors . . . of any fiduciary duties . . . including with respect to deciding . . . to enter into a contract with a stockholder, [or] . . . deciding to whether to perform . . . or breach, the contract." This must be taken with a grain of salt however, given that the entire point of the proposed amendment is to expressly do away with the fiduciary obligation of directors under Abercrombie to refrain from impairing their ability to "use their own best judgment on management matters." With Abercrombie removed, any remaining fiduciary duties that must be observed in entering into an activist settlement agreement would seem to be limited to Unocal (and, in the case of contracts with controllers, entire fairness). As noted above, a Unocal challenge may be difficult to sustain in the context of the settlement of a proxy contest.

Further, the fact that the synopsis encourages directors to breach the settlement agreement in the event their fiduciary duties in the future so require seems a further permission to allow directors to cause the company to enter into an agreement that sets up a potential choice between breach of contract (presumably somewhat expensive) and breach of fiduciary duties (ditto). This is certainly not a model that Delaware has encouraged in the M&A context – it would be hard to imagine a merger agreement with no fiduciary out, or where exercising the fiduciary out could result in uncapped damages. But entering into agreements that set up this choice – subjecting the exercise of fiduciary duties to a potentially serious penalty – perhaps is something that Delaware is now ready to embrace.

13. Protecting Long-Term Investor Interests in Activist Engagements, State Street Global Advisors, October 10, 2016.

14. Larry Fink, Profit and Purpose, 2019 Letter to CEOs.

15. Larry Fink, A Sense of Purpose, 2018 Letter to CEOs.

16. Note that veto rights to date have not commonly been part of the ask from activists, though anecdotally, some activists have asked for approval rights on mergers and other significant transactions. The Delaware amendment would make it harder to beat back these requests.

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