New Enterprise Associates 14, L.P. v. Rich, 295 A.3d 520 (Del. Ch. May 2, 2023)1

Rejecting the argument in a motion to dismiss that a covenant not to sue for breach of fiduciary duties in a stockholder agreement that applied to drag-along transactions was facially invalid, the Delaware Court of Chancery held that such covenants can be legitimate forms of "fiduciary tailoring" and provided fact-specific test for determining their validity.

Background 

The decision (the "NEA" decision) involved a motion to dismiss in a case brought by venture funds (the "Funds") challenging the drag-along sale of Fugue, Inc. (the "Company"), a company in which they were early stage investors. After a sale process in 2020 and early 2021 failed, the Company raised new capital from an investor group led by defendant George Rich ("Rich"), and a few existing investors. The Funds did not participate. The financing transaction involved a recapitalization of the Company in which existing preferred was converted to common, and investors in the financing purchased Series A-1 Preferred Stock. It was a condition to closing that all new investors, and certain existing investors, including the Funds, execute a voting agreement that contained a drag-along provision and a covenant not to sue Rich or his affiliates and associates in connection with a drag-along sale, including for breach of fiduciary duty (the "Covenant").

In July 2021, the Company's board (by then consisting of just Rich, a designee of his, and the CEO) authorized the issuance and sale of additional shares of Series A-1 Preferred Stock to Rich and some of the other investors through an extension of the earlier financing. The board also authorized equity awards to management and large equity grants to the directors.

The Company's CEO was first contacted about a potential acquisition in June 2021. This outreach resulted in a merger agreement being signed and the deal closing in February 2022. In February 2022, the Company reached out to existing investors with a form merger agreement, notifying them of their obligation to support the transaction under the drag-along provision by signing a joinder agreement and a voting form. The Funds refused to sign unless Rich and the CEO affirmed that they had not communicated with the potential acquiror about a sale of the Company prior to the recapitalization. In May 2022, when the affirmation was not forthcoming, the Funds filed the lawsuit challenging the drag-along sale and alleging breach of fiduciary duty by the directors of the Company and Rich, as a controlling stockholder, in approving the drag-along sale. The Funds claimed that the drag-along sale was an interested party transaction subject to entire fairness because it conferred a unique benefit on Rich, as controlling stockholder, and the directors, as a result of extinguishing derivative claims related to their self-dealing in the July 2021 Series A-1 Preferred extension and equity grants. The key issue in the motion to dismiss was whether the Covenant barred the Funds' claims. 

Court's Decision

The NEA court noted the competing considerations of Delaware law's pro-contractarian nature, and public policy considerations in preserving fiduciary accountability in the absence of express statutory authority to limit it.

The court considered the Funds' argument that the Covenant was facially invalid because Delaware law does not permit parties to waive the duty of loyalty in Delaware corporations, as evidenced by exclusion of loyalty claims from DGCL Section 102(b)(7). The court distinguished Totta v. CCSB Financial Corp., 2 a recent decision that seemed to support the Funds' argument, on the basis that it dealt with a charter provision and not a stockholder agreement. The court also distinguished Delman v. GigAcquisitions3, LLC3 because the defendants in that case attempted to justify the purported waiver of the duty of loyalty on public disclosure and assumption of the risk. The NEA court held that while the Funds' argument for facial validity was reasonable, it ignored the importance of private ordering through stockholder agreements.

The NEA court undertook a detailed analysis of arguments against facial invalidity. The court held that such a covenant would not be facially invalid under trust or agency law. Looking to Delaware statutory law, the court held that Section 102(b)(7) indicated that the Covenant should be valid insofar as it dealt with waivers of direct claims for breach of the duty of care, or for claims based on gross negligence, or recklessness. The court also held that other DGCL provisions evidence support for fiduciary tailoring, and undermined the argument for facial invalidity of the Covenant, such as Section 122(17), which permits corporate opportunity waivers, Section 102(a)(3), which permits limits on corporate purpose, Section 141(a), which permits charter provisions that narrow the powers and duties of the board, and Section 145, which authorizes limitations on fiduciary accountability. The court held that several common law doctrines also indicate that the Covenant was not facially invalid, such as the principle that "contractual obligations preempt overlapping fiduciary claims,"4 the doctrine of advance ratification,5 and the doctrine of laches.6

The NEA court looked to Manti Holdings, LLC v. Authentix Acquisition Co. 7 for guidance on how the Delaware Supreme Court had treated the similar public policy issue in the context of advance waivers of appraisal rights, also in connection with a drag-along sale. The Manti court held that the appraisal waivers were not facially invalid because appraisal rights were not "sufficiently important in regulating the balance of power between corporate constituencies" to justify prohibiting "sophisticated and informed stockholders" from agreeing to advance waivers of them. The Manti court also held that the advance waivers were not invalid under an as applied challenge given that they were logically related to the drag-along provisions, and due to factors such as the waivers not having been unilaterally imposed on stockholders, the stockholders were sophisticated institutions, there was no imbalance of information, and the stockholders understood the implications of the waiver and gave knowing waivers.

In light of Manti and the above considerations, the NEA court set forth a two-part test for determining the validity of fiduciary waivers, the first step concerning facial validity and the second step concerning an "as applied" test. Under the first step, "the provision must be narrowly tailored to address a specific transaction that otherwise would constitute a breach of fiduciary duty." Under the second step, a court should consider whether the waiver is "reasonable" based on factors such as the following: "(i) the presence of the provision in a bargained-for contract, (ii) the clarity and specificity of the provision, (iii) the stockholder's level of knowledge about the provision and the surrounding circumstances, (iv) the stockholder's ability to foresee the consequences of the provision, (v) the stockholder's ability to reject the provision, (vi) the stockholders' level of sophistication, and (vii) the involvement of counsel." The court also invoked an overriding requirement for validity that a fiduciary waiver could not foreclose claims for intentional or bad faith breaches of fiduciary duty. 

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Footnotes

1. https://courts.delaware.gov/Opinions/Download.aspx?id=347110

2. 2022 WL 1751741 (Del. Ch. May 3, 2022)

3. 288 A.3d 692 (Del. Ch. 2023)

4. See Nemec v. Shrader, 991 A.2d 1120, 1129 (Del. 2010)

5. See, e.g,,. In re Invs. Bancorp, Inc. S'holder Litig., 177 A.3d 1208, 1222 (Del. 2017)

6. See, e.g., Lebanon Cnty. Empls.' Ret. Fund V. Collis, 287 A.3d 1160, 1194 – 95 (Del. Ch. 2022)

7. 261 A.3d 1199 (Del. 2021).

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