Battle Over Shareholder Pacts Strains Delaware’s Business Courts
State legislature rushes to shore up stockholder agreements after Chancery Court rulings limited them
Sweeping changes to Delaware corporate law could give more power to influential shareholders, letting them make more deals on behalf of the company without board oversight.
The proposed bill expands the breadth and power of stockholder agreements, which are often used by activist investors to gain board seats and by founders to coordinate control.
It was adopted in the legislature in the wake of recent decisions by the state’s specialized business court and has drawn criticism from that court’s chief judge. Gov. John Carney plans to sign the bill into law, a spokeswoman said, and it would take effect Aug. 1.
The changes come as Delaware’s legal system faces criticism on several fronts, including from Tesla chief executive Elon Musk. Texas and other states are also looking to persuade corporations to shift their legal home from Delaware.
As the legal residence of about two-thirds of S&P 500 companies, Delaware decides many disputes between shareholders and companies through its Chancery Court. Its precedents influence corporate law in other states.
Stockholder agreements between boards and activist investors, private-equity firms and others are commonly used to give the investors a say in hiring and firing executives or merger approvals. They can also give founders veto power over debt levels, board committee membership or executive appointments. Goldman Sachs’s top partners, including those on the board, have long coordinated their votes with a stockholder agreement.
Business complaints
Delaware’s lawmakers pushed the measure forward after complaints from companies and others that several of the Chancery Court’s decisions threatened to undermine the validity of existing stockholder agreements.
Among them is a February opinion from Vice Chancellor Travis Laster over an agreement giving a founder veto power over the board. Laster said the agreement violated Delaware law in blocking the board from using its best judgment in governance.
Companies said this ruling clashed with common market practices, and pointed to other recent cases that weighed in on merger-agreement processes and board power.
The new legislation would establish in state law that companies may enter into these kinds of agreements with stockholders without having to amend their charters or articles of incorporation. Changing those foundational documents typically requires shareholder approval.
‘Rushed reaction’
The proposal drew criticism from legal practitioners and more than 50 law professors, who in a letter warned lawmakers that the legislation would give free rein to influential shareholders in ways that could hurt other investors. In a rare move, Chancellor Kathaleen McCormick—the head of the state’s business court—criticized the proposal, calling it a “rushed reaction.”
Laster has posted on his LinkedIn page about the legislation, a departure from norms in a state where Chancery judges seek to appear above the political fray. In one post, he said he supported a “more targeted solution.” In another, he marshaled extensive arguments from both sides, adding: “The legal academy does not come out in force for business-as-usual updates.”
“The law raises some fundamental questions about corporate governance,” said Stephen Bainbridge, a law professor at the University of California, Los Angeles who signed the letter in opposition. “The issue of, ‘Should boards be able to essentially give away their powers through contract?’ There is a lot of disagreement about that.”
The stakes are high for Delaware. “Keeping companies incorporated in Delaware is job one in that state,” he said.
Roughly two million businesses choose the tiny state as their corporate home, including about 68% of Fortune 500 companies and nearly 80% of initial public offerings, the state says. Corporate-franchise taxes and related abandoned-property collections approach 30% of Delaware’s general revenue, state reports show.
CEOs and big shareholders of some companies, including most prominently Musk, have railed against what they call undue meddling by Delaware’s court in corporate decisions. Tesla shareholders recently approved the company’s reincorporation in Texas, and Musk has urged others to leave Delaware.
Other states are positioning themselves as competitive alternatives. Texas has formed new business courts and Nevada boasts rules that can shield directors and officers from some kinds of shareholder litigation.
So far, Delaware isn’t experiencing a corporate exodus. Attorneys say the state’s decades of precedent and army of experienced attorneys give companies predictability they can’t be as sure of elsewhere.
Veto power dispute
In February, Laster’s 132-page opinion invalidated an agreement giving founder and CEO Ken Moelis sweeping veto power over future board decisions at the investment bank bearing his name.
Laster acknowledged such agreements are widespread, but wrote that “market participants must conform their conduct to legal requirements, not the other way around.” The lawsuit was brought by a Florida firefighters’ pension fund that held Moelis & Co.shares.
Critics said the ruling undermined widely established market practices.
“The uncertainty that it created was an invitation to more litigation,” said Lawrence Hamermesh, a former professor at Widener University’s Delaware Law School. The need for clarity over these agreements justifies the subsequent legislation, he added.
Lawmakers, at the urging of a branch of the Delaware State Bar Association, rushed to shore up shareholder agreements even before an appeal in the Moelis case reached the Delaware Supreme Court.
One opponent, Joel Fleming, a partner at the law firm Equity Litigation Group, said it moves Delaware away from its traditional “board-centric model,” which helped make the state attractive to investors and companies alike. Boards typically can’t tie the hands of their successors when it comes to critical management decisions, he said.
“The reason Delaware has been successful is because it’s perceived as neutral and balanced between management and public investors,” Fleming said.
Other attorneys say the Chancery Court decisions were fairly narrow, and the legislative changes leave in place a board’s fiduciary obligations to shareholders.
“I don’t think that people are just going to start entering into agreements that eviscerate the function of a board under Delaware law,” said William Regner, a partner with law firm Debevoise & Plimpton.