Monday, June 24, 2024
Fiduciary Duties Trump Contracts?!
Many in the business law world have been following the saga involving the adoption of S.B. 313 by Delaware's General Assembly last week. S.B. 313 adds a new § 122(18) to the General Corporation Law of the State of Delaware (DGCL) that broadly authorizes corporations to enter into free-standing stockholder agreements (not embodied in the corporation's charter) that restrict or eliminate the management authority of the corporation's board of directors. See my blog posts here and here and others cited in them, as well as Ann's post here.
In the floor debate on S.B. 313 last Thursday in the Delaware State House of Representatives, a proponent of the legislation stated that fiduciary duties always trump contracts. That statement deserves some inspection in a number of respects. I offer a few simple reflections here from one, limited perspective.
The historical centrality of corporate director fiduciary duties (which were the fiduciary duties referenced on the House floor) is undeniable. Those who have taken business associations or an advanced business course with me over the years know well that I emphasize in board decision making that the directors’ actions must be both lawful and consistent with their fiduciary duties in order to be legally valid and enforceable. I doubt my teaching is exceptional in that regard.
But the floor debate involved a different kind of tangle between legal obligations and fiduciary duties than exists in the board decision-making context in which corporate action is written on a tabula rasa. The comment made in last Thursday’s legislative session responded to the suggestion that a board of directors may later decide to breach a contract that is lawful and was approved by the board in a manner that is consistent with director fiduciary duty compliance. That scenario involves board action to disregard the terms of an agreement—by authorizing and directing the corporation to breach a legal obligation of the corporation because the directors have, in good faith and with due care, determined that the breach of contract is in the best interest of the corporation.
This type of board action is certainly not unprecedented. An example from my practice immediately springs to mind: no-shop, non-solicitation, and related clauses in business combination (M&A) agreements. These provisions may be (or at least appear to be) lawful and compliant with director fiduciary duties when made but may interfere with a target board’s fiduciary duties if the board later determines it has a fiduciary obligation to engage in interactions with a potential transactional partner in violation of that type of deal protection provision.
The resolution of this issue in the M&A context has largely been contractual. Fiduciary outs of various kinds have been common in M&A agreements for decades. (I gave my first CLE talk on them back in the 1980s.) Through these provisions, directors consider and prepare in advance for the potentiality of a later conflict between the deal protection obligations of the corporation and their fiduciary duties to the corporation. Properly drafted, fiduciary outs help protect the legal validity and enforceability of the original contract from future challenge and preserve the board’s legal right to respond to new circumstances without breaching the contract.
As those who work in this space well know, a watershed case involving deal protection provisions is Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914 (Del. 2003). In its Omnicare opinion, the Delaware Supreme Court assesses the validity of a merger agreement that effectively locked up a majority of the votes needed to approve the merger. The merger agreement did not include a fiduciary out provision. The directors had no ability to terminate the merger agreement or nullify its terms to comply with their fiduciary duties without breaching the contract. The court found the deal protections invalid and unenforceable.
Proponents of S.B. 313 clearly state that a corporation's exercise of its authority to enter into stockholder agreements under § 122(18) will be subject to challenge if the directors breach their fiduciary duties to the corporation in approving a stockholder agreement or in later authorizing the corporation's performance under that agreement. If the corporation's directors are found to be in breach, the stockholder agreement then may be found invalid or unenforceable. The prospect of that occurring in the stockholder agreement context is as real as it is in the M&A deal protection context.
Perhaps, then, fiduciary outs are a best practice that should grow out of the new DGCL § 122(18). If the parties truly intend for fiduciary duties to trump the contract (as the bill proponents have claimed) and we can anticipate challenges in that regard based on the nature of the agreement, stockholder agreements should provide in advance for the eventuality of a conflict. Otherwise, a stockholder agreement authorized under DGCL § 122(18) may be found either invalid ex post because the board’s original approval of the agreement may later be determined to have been a breach of the directors’ fiduciary duties (for failure to include a fiduciary out, as in Omnicare) or unenforceable in litigation over a board decision to breach or refrain from breaching the agreement in the face of a perceived fiduciary duty conundrum related to the corporation’s performance under the terms of the agreement. A well-crafted fiduciary out (which would undoubtedly be somewhat bespoke, as it should be in the M&A context, based on the nature of the corporation’s obligations in the contract) should help avoid litigation, or at least enable its early dismissal, in the event of either type of legal claim.
Your reactions to these musings are, as always, welcomed. We will be operating in new territory here assuming the Governor of Delaware signs S.B. 313 into law (as he has signaled). If I am missing an element of statutory or decisional law or strategic litigation practice that impacts my arguments, I would appreciate hearing about it. Regardless, it is now time that we all think about how to address anticipated issues arising from the Pandora’s box that the Delaware General Assembly has opened. That may include practice-oriented solutions to perceived legal questions or tensions as well as potential further adjustments to the DGCL. As to the latter, I note that I raised in one of my earlier posts the desirability of looking at DGCL subchapter XIV in light of the provisions of DGCL § 122(18). Perhaps that issue merits a subsequent post . . . .
https://lawprofessors.typepad.com/business_law/2024/06/fiduciary-duties-trump-contracts.html
Comments
Thanks, Mohsen. I appreciate you weighing in. I want to think through your comments. But I am speaking at a conference today. Be sure I will get back to you if I have salient thoughts or questions.
Posted by: joanheminway | Jun 24, 2024 10:19:20 AM
As in-house counsel (and not an academic), I agree that I think it's possible to square Mohsen Manesh's interpretation of Nemec v. Shrader (contract trumps FDs, but subject to breach remedies).
But, I don't know how you square 122(18) with Carmody v Toll Brothers (invalidating dead hand poison pills), which Brian Quinn discusses. Curious how much actual DE case law was completely superseded and "overturned" and if things long thought out of style come back. Wasn't the explicit point of the amendments to bring into conformity the practice and the text?
*these views are my own and don't necessarily represent those of my employer.
Posted by: David Brown | Jun 24, 2024 12:35:38 PM
Thanks, David, for these additional thoughts. I will compose a more complete reply once I break through of my conference responsibilities. (I am on the West coast.) But I will note briefly here that I had thought of using poison pills as my exemplar rather than business combination agreements (since they also are agreements that can create fiduciary duty questions both at the time of approval and at a later date). As a result, I likely will have more to say about your comment alone and as it ties in with Mohsen's thoughts, hopefully later tonight.
Posted by: joanheminway | Jun 24, 2024 1:35:38 PM
Thanks, again, Mohsen and David, for your comments on this post. I am appreciating the conversation. I will offer some clarification on my post and a response to you both here.
By way of clarification, my post intends to suggest a best practice, not argue categorically that the absence of a fiduciary out will render a stockholder agreement invalid or unenforceable per se. However, my hunch (and remember here that I am not a litigator) is that the inclusion of a fiduciary out in a stockholder agreement will help a corporation in arguing that approval and execution of the stockholder agreement not only was a valid exercise of the corporation’s corporate power under DGCL 122(18) but also represented action undertaken consistent with the directors’ fiduciary duties. Regardless, the inclusion of a fiduciary out resolves the inherent conflict posed by the scenario in which directors must authorize the corporation’s breach of the stockholder agreement to comply with their fiduciary duties. Well before the Omnicare decision, fiduciary outs were used in this way in M&A agreements. I hope this better (or at least more succinctly) explains what I intended to convey.
As for some responses, . . .
Mohsen, you are right that the Moelis stockholder agreement did not include fiduciary outs, as far as I know. However, fiduciary outs were irrelevant to the Moelis decision, since the court decided the case based on a violation of DGCL § 141(a). Because the provisions at issue were unlawful, the court never had to get to fiduciary duty questions.
You also are right that “the intent of 122(18) is very clearly to provide for a ‘different rule’ than the Moelis decision.” DGCL § 122(18) forecloses the argument, successfully made in Moelis, that the contended stockholder agreement provisions were unlawful under DGCL § 122(18) because they were neither included in the corporation’s charter nor otherwise authorized in the DGCL. DGCL § 122(18) provides that source of authority.
David, I read Nemec as a different type of case from the ones I describe in the post. In Nemec, the court found that contractual duties governed and effectively supplanted the directors’ fiduciary duties. Unless I am missing something, stockholder agreements do not create contractual duties that are intended to operate in lieu of director fiduciary duties. To the contrary, the bill synopsis provides that:
“New § 122(18) does not relieve any directors, officers or stockholders of any fiduciary duties they owe to the corporation or its stockholders, including with respect to deciding to cause the corporation to enter into a contract with a stockholder or beneficial owner of stock and with respect to deciding whether to perform, or cause the corporation to perform, or to breach, the contract, whether in connection with their management of the corporation’s business and affairs in the ordinary course or their approval of extraordinary transactions, such as a sale of the corporation.”
Carmody is, however, on point with Moelis in a relevant part. In Carmody, the claim related to both the statutory authority for a dead hand provision and the exercise by the directors of their fiduciary duties in approving the dead hand provision. The court found that both claims were legally viable and denied the defendant’s motion to dismiss. If the legislature later had approved an augmentation of the corporate powers under DGCL § 122 to broadly authorize dead hand provisions, then the statutory authorization issue would no longer exist, but the fiduciary duty issue would remain. That is what ai understand the purpose and effect of DGCL § 122(18).
I will not speculate, given the detailed nature of the Moelis opinion and the novelty of DGCL § 122(18) as to how much in prior Delaware decisional law may be “completely superseded and ‘overturned’ and if things long thought out of style come back.” But I am sure that we’ll see a few things along those lines come up and that interpretations of preexisting law may need to be revised.
I also am hesitant to offer a view on whether “explicit point of the amendments [was] to bring into conformity the practice and the text.” Certainly, that comment was made by some in the Senate and House proceedings I attended. But others offered different explanations. It may be fair to say that there are a number of rationales for the provisions included in S.B. 303.
I again want to thank both of you for your engagement on all this.
Posted by: joanheminway | Jun 25, 2024 8:17:07 AM
Interesting post, Joan. I'm puzzled though why the proponents think that "a corporation's exercise of its authority to enter into stockholder agreements under § 122(18) will be subject to challenge if the directors breach their fiduciary duties to the corporation in approving a stockholder agreement or in later authorizing the corporation's performance under that agreement." Maybe I'm less puzzled about why the contract might be invalid where they breach their fiduciary duties in contract formation. But very puzzled why the contract would be invalid post Section 122(18) if the board breached their fiduciary duties in performing. To be clear, I think this is true under the current regime. In other words, I think it's true currently (although perhaps not for long) that you need a fiduciary out to make certain contracts valid in light of one's fiduciary duties. But I don't think that's because in the absence of a fiduciary out, and assuming that performance constitutes a fiduciary breach, it is the possibility of a fiduciary breach that invalidates the contract. Rather, the contract is invalid in the absence of a fiduciary out because of Section 141(a). VC Laster I think does a good job explaining this point in Moelis. He says that a contract like the one in QVC or Omnicare isn't invalid because performance would constitute a fiduciary breach. It's invalid because it violates Section 141(a). But if Section 122(18) is meant to render such contracts valid under Section 141(a), then I don't see how a fiduciary breach in performance could ever render the contract invalid. In that case, I don't think there would be any need for fiduciary outs under the new regime in order to render the contract valid. Unlike under the current regime, post-Section 122(18) the contract would be valid with or without them. To be sure, a fiduciary out might be necessary to avoid breaching the contract consistent with one's fiduciary duties. But I don't think the validity of the contract itself would be subject to challenge.
Posted by: Zack Gubler | Jun 26, 2024 11:02:17 AM
Hi, Zack. I think your questions may just relate to a difference in semantics. But for the benefit of all, I will just rearticulate my understanding of the Delaware courts’ manner of reviewing board decision making.
Director action may be invalidated by the court for one of two reasons: either it is unlawful because the action is prohibited (or otherwise not authorized) by law or it represents a breach of the directors’ fiduciary duties or other inequitable conduct. So many of the more complex classic cases we teach are ultimately fiduciary duty/equitable conduct cases—Schnell, Blasius, Household, Unocal, etc. In these cases, the court finds the board’s action (e.g., respectively, moving the annual meeting date, increasing the size of the board, adopting a stockholder rights plan, engaging in a self-tender) is legally authorized under the DGCL (as interpreted judicially) and the relevant corporation’s charter and bylaws. However, the actions were ultimately invalidated because of inequitable conduct.
Moelis is a case in which the board’s conduct violated statutory law. As you note, Vice Chancellor Laster finds provisions in the stockholder agreement unlawful because they conflict with statutory law—Section 141(a) of the DGCL. As a result, the Moelis opinion does not approach fiduciary duty questions.
Without putting words in the mouths of the proponents of DGCL § 122(18), then, what they intended to address and did address in their drafting is the statutory authority issue—whether a board of directors of the Delaware corporation may, as a matter of statutory law, enter into an agreement with a stockholder to shift management authority to the stockholder in certain ways. Presumably, they chose to do this in DGCL § 122, which sets forth the powers of the corporation, to clarify that intent and achieve that objective. However, the proponents and the bill synopsis noted that the fiduciary duty question is still one for a reviewing court to properly address.
So, I think your question relates to the concept of validity in these contexts. Is the concept of validity synonymous with legal authority, or does it mean more than that—legally authorized and also consistent with the directors’ fiduciary duties? I believe the proponents’ reference to validity encompasses both concepts/levels of analysis. In my experience, common descriptions of court opinions in which actions of a corporate board are struck down label the effect of the court’s action as invalidating the board’s action.
I hope this addresses your questions/concerns about the possible ways in which the action of the board in adopting a stockholder agreement may later be invalidated by a court. But let me know if I can say more.
Posted by: joanheminway | Jun 27, 2024 5:37:48 AM
I agree that 122(18) does not alter the fiduciary duties owed by directors, including the fact that directors must comply with their fiduciary duties when deciding (1) initially whether to enter into SH agreements or (2) later whether to comply or breach such agreements. In that respect, yes, it is correct to say “fiduciary duties always trump contracts.”
But it’s not clear to me that fiduciary outs are required to make a 122(18) contract enforceable against the corporation. And in the absence of such a requirement, it’s not clear to me that we’ll see them become a part of market practice.
First, with respect to a board’s initial decision, a pre-IPO company might agree to a SH agreement with its controlling SHs with no fiduciary out, and thereafter sell shares to public investors. As VC Laster has point out, under current DE precedent, those public investors will lack standing to challenge board’s decision that were made before the public investors because SHs. (There might be different result for an already public company that agrees to a 122(18) contract with an activist.)
Second, the bill’s synopsis contemplates that a board’s fiduciary duties may require a board to breach a 122(18) agreement, but the statutory language still provides that corporation will be subject to whatever remedies available under applicable law for any breach. In that sense, the statute suggests a fiduciary out is unnecessary. The board always has an implicit out; it’s breach of contract, though there will be consequences.
Finally, the Moelis SH agreement, which VC Laster found to be invalid, did not have any fiduciary outs (unless I missed that somewhere), and the intent of 122(18) is very clearly to provide for a “different rule” than the Moelis decision.
Posted by: Mohsen Manesh | Jun 24, 2024 10:11:09 AM