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Delaware Court of Chancery Upholds Covenant Not to Sue for Breach of Fiduciary Duty
May 17, 2023 Download PDF
In New Enterprise Associates 14, L.P. v. Rich, the Delaware Court of Chancery, in an opinion by Vice Chancellor Laster, held that a contractual covenant by stockholders not to sue for breach of fiduciary duty in connection with a drag-along sale is enforceable under Delaware law if it is narrowly tailored and reasonable under the circumstances. In doing so, the court cautioned that the case under consideration presented an “optimal” circumstance for enforcement because it involved a clear, specific covenant bargained for by sophisticated parties, and that such provisions may not be enforceable in other contexts. To that end, the court indicated that such a covenant may not be enforced in the case of intentional breach of duty, and thus the court denied the defendants’ motion to dismiss with respect to allegations that preferred stockholders acted intentionally and in bad faith to benefit themselves and harm the common stockholders during the lead-up to the challenged drag-along sale.
The plaintiffs are investment funds managed by sophisticated venture capital firms that invested in a startup company called Fugue, Inc. After a few years, the plaintiffs encouraged the company to seek a liquidity event, and the company spent six months looking for a buyer to no avail. After the plaintiffs declined to increase their financial commitment, management represented that the only option forward was an equity investment from an investor group led by George Rich, who would only commit to a deal if (i) all existing preferred stock were recapitalized into common stock, (ii) Rich and his fellow investors received a new class of preferred stock and (iii) the plaintiffs and other significant investors executed a voting agreement (the “Voting Agreement”). Various existing stockholders and employees invested in the new preferred round, but the plaintiff funds expressly declined the opportunity to participate.
The Voting Agreement contained a drag-along provision requiring the signatories (including the plaintiffs) to participate in and otherwise support sales approved by the board and a majority of the preferred stock, and that satisfied specific criteria. The drag-along provision also included a covenant that the signatories would not sue Rich, his affiliates or his associates over such a drag-along sale, including by asserting claims for breach of any fiduciary duty (the “Covenant”).
Later that same year, the board (which, following the resignation of two independent directors, consisted of Rich, a director appointed by the preferred stockholders and the company’s CEO) approved a second closing of the recapitalization on the same terms as the initial investment as well as stock option grants to directors and other employees. Within months thereafter, the board agreed to sell the company in a transaction that met the requirements of a drag-along sale under the voting agreement. They informed the plaintiffs of their obligation to vote in favor of the merger and against competing proposals pursuant to the drag-along provision. Plaintiffs agreed to do so if Rich and the other preferred stock director attested that they had not had any communications with the acquirer about a potential transaction before the recapitalization. When Rich and the preferred director only agreed to sign substantially narrower affirmations, the plaintiffs refused to vote in favor of the merger or sign the accompanying joinder and sued the directors for breach of fiduciary duties in connection with the drag-along sale. The directors moved to dismiss, arguing that the Covenant foreclosed the plaintiffs’ claims.
The court engaged in a lengthy discussion of whether covenants not to sue for breach of fiduciary duty are enforceable under Delaware law. This included reviewing numerous aspects of trust, agency, contract and corporation law (including certain provisions of the Delaware General Corporation Law (DGCL)) that permit parties to tailor fiduciary relationships. The court also cited the Delaware Supreme Court’s opinion in Manti Holdings, LLC v. Authentix Acquisition Co. permitting stockholders to waive statutory appraisal rights by contract. Ultimately, the court concluded that contractual agreements by stockholders not to sue for breach of fiduciary duty are not facially invalid under Delaware law, but a court must scrutinize them closely under 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. As to the required level of specificity, the court wrote that it must “compare favorably with what would pass muster for advance authorization in a trust or agency agreement, advance renunciation of a corporate opportunity under [DGCL] Section 122(17), or advance ratification of an interested transaction like self-interested director compensation.”
- Second, the provision must survive close scrutiny for reasonableness based on non-exclusive factors set forth in Manti, including (i) the existence of a written contract formed through actual consent, (ii) the clarity of the provision, (iii) the sophistication of the parties and whether they understood the provision’s implications, (iv) the covenanting party’s ability to reject the provision and (v) the presence of bargained-for consideration.
Here, the court concluded that the Covenant met the first requirement of the test, as it only applied to certain sale transactions meeting contractually specified criteria necessary. The Covenant also met the reasonableness test; it was a clear, express provision appearing in the voting agreement that was agreed to by the plaintiffs, who were sophisticated parties that could have rejected the Covenant. The court also explained that invalidating the Covenant would alter the bargained-for exchange, as the plaintiffs agreed to the provision to induce Rich and the other investors to fund the recapitalization.
Importantly, the court applied a public policy limitation to this framework, namely, that contracting parties cannot exempt a party from tort liability for intentional conduct. Analogizing breach of fiduciary duty to a type of equitable tort, the court also ruled that a covenant not to sue for breach of fiduciary duty cannot prevent a party from asserting a claim for an intentional or bad faith breach.
- Covenants not to sue for breach of fiduciary duty would be facially valid in common M&A situations involving sophisticated parties, but may not be enforceable depending on the particular facts. The court noted that this case was an “optimal scenario for enforcement,” given, among other things, the clear and specific nature of the Covenant and the sophistication of the plaintiffs. But, according to the court, a similar covenant adopted in different context “would face deep skepticism and a steep uphill slog,” including, among others, in the context of an agreement with a retail stockholder, an employee stock grant, a dividend reinvestment plan, an employee stock compensation plan or a stock transmittal letter.
- The exception for intentional or bad faith breach of fiduciary duty is broad. While the court clarified that covenants not to sue for breaches of fiduciary duty are, in the right context, enforceable in Delaware, the public policy limitation applied by the court significantly curtails the universe of claims that such covenants can effectively foreclose. Because fiduciaries are typically exculpated for monetary damages for breach of the duty of care, such covenants are most useful to foreclose claims for breach of the duty of loyalty. But, to be foreclosed, the fiduciary must have believed in good faith that the nevertheless self-interested transaction was not contrary to the best interests of the company, which may apply in fewer circumstances and be difficult for litigants to dismiss on the pleadings without a developed factual record.
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 The court also observed that the Covenant is included in the National Venture Capital Association’s model voting agreement (albeit in brackets for drafters to consider), and one of the funds was a member of the NVCA.