Corporate & Securities Blog

Delaware Chancery Court Examines ‘Reasonable Efforts’ in Chordia Decision

Most contracts will straightforwardly require the parties to take or refrain from taking specified actions. However, some contracts require that a party attempt to bring about a result that may or may not be within the party’s control. Such provisions are commonly qualified so that the party will not have breached the provision, even if the goal is not achieved, so long as the party has used its “reasonable efforts” to bring about the desired result.

Because the steps that a party must take to satisfy a reasonable-efforts requirement will depend on the facts and circumstances surrounding the obligation, lawyers may struggle to advise their clients on what is required to satisfy such an “efforts clause.” In the recent case of Chordia v. Lee, the Delaware Court of Chancery reviewed the factors to be considered in analyzing an efforts clause while holding that a majority stockholder had failed to use its reasonable efforts to carry out the terms of a stockholders’ agreement.

What Happened in Chordia?

Zenith Electronics LLC, an indirect, wholly owned subsidiary of major appliance and consumer electronics company LG Electronics Inc., purchased a controlling interest in ad tech company Alphonso Inc. in 2020. Although Alphonso’s founders wanted to retain control of the company so that they could drive it toward an initial public offering, the founders and other Alphonso stockholders (the key holders) ultimately settled for significant upfront cash together with some heavily negotiated minority protections.

The key holders’ minority protections were intended principally to preserve liquidity for their minority interests in Alphonso. Specifically, the parties entered into a stockholders’ agreement that gave the key holders a demand registration right exercisable after December 2025 and a right to annual tender offers in 2024, 2025 and 2026. These liquidity rights were protected, in turn, by the combination of (1) a right of the key holders to appoint up to three of the seven directors on Alphonso’s board and (2) a prohibition on any change to the registration right or the scheduled tender offers absent the consent of at least one director appointed by the key holders.

The key holders’ right to appoint directors to the Alphonso board was subject to two conditions. First, they had to retain collective ownership of at least 10 percent of Alphonso’s outstanding shares. Second, at least one of the key holders had to remain as an officer or employee of Alphonso. LG Electronics had the right to terminate the stockholders’ agreement in its entirety if all key holders ceased to serve as officers and employees of Alphonso. The stockholders’ agreement further provided that Alphonso’s board — controlled by four LG Electronics-appointed directors — retained the exclusive right to terminate the employment of Alphonso’s officers and any of its employees with annual compensation of $500,000 or more, which applied to five of the key holders (the executive key holders).

As the court noted, “Given these mechanics, it might seem that [the key holders’ right to appoint Alphonso directors] requires protection of its own.” That protection, according to the key holders, was to be found in the stockholders’ agreement’s efforts clause, which read: Alphonso “agrees to use its reasonable efforts, within the requirements of applicable law, to ensure that the rights granted under this Agreement are effective and that the Parties enjoy the benefits of this Agreement. Such actions include, without limitation, the use of [Alphonso’s] reasonable efforts to cause the nomination and election of the directors as provided in this Agreement.”

Not long after the closing, friction developed between LG Electronics and the executive key holders, including LG Electronics’ realization that a sale of Alphonso pursuant to the key holders’ liquidity rights would be inconsistent with LG Electronics’ long-term objective of incorporating Alphonso’s technology into LG Electronics’ products. By mid-2022, LG Electronics sought ways to terminate the stockholders’ agreement and eliminate its obligations to the key holders.

At the end of the year, Alphonso’s board held a special meeting at which the board (1) terminated the employment of the five executive key holders and (2) elected a new interim CEO, who immediately fired the two remaining key holders who were neither officers nor employees with annual compensation of $500,000 (the non-executive key holders). Later that day, Zenith signed a written consent (the December consent) removing all Alphonso directors who had been appointed by the key holders. On March 30, 2023, the key holders filed a complaint seeking an order pursuant to Section 225 of the Delaware General Corporation Law that Zenith’s removal of the directors appointed by the key holders pursuant to the December consent was invalid and, therefore, those directors remain members of Alphonso’s board. The court agreed with the key holders.

Chancery Court Examines Efforts Clause with Four-Factor Analysis

After determining that a court hearing a case under Section 225 of the Delaware General Corporation Law could decide an appropriately tailored breach of contract claim, the court conducted an analysis that “begins and ends with the ‘reasonable efforts’ provision in the Stockholders’ Agreement.” Specifically, the court focused its analysis on four questions: “(1) which parties are required to use reasonable efforts, (2) toward whom reasonable efforts must be used, (3) the scope of the obligation imposed by the words “reasonable efforts,” and (4) whether the party that must use reasonable efforts acted in the manner required by the obligation toward those to whom reasonable efforts must be used.”

Which Parties Must Use Reasonable Efforts?

Turning to the first of these questions, the court, while noting the “truism that a corporation acts through individuals,” nonetheless also noted that “the Stockholders’ Agreement itself distinguishes in various instances between Alphonso and the Board,” treating the board and Alphonso as distinct parties with differing rights and obligations. This distinction was so prevalent that “in some instances the Stockholders’ Agreement refer[red] separately to the Board and Alphonso in the same provision.” Under these circumstances, the court adopted the defendants’ approach and interpreted the rights and obligations under the stockholders’ agreement as applying separately to Alphonso and to its board. This was important because the efforts clause, by its terms, applied only to Alphonso and not to the board.

In determining which human agents’ actions should be attributed to Alphonso, the court relied on the theory that a corporation acts through its officers and held that the interim CEO, in particular, acted for Alphonso. (In a footnote, the court indicated that it would reach the same result on the alternate theory that the acts of a corporation’s officers, acting within the scope of their authority, are imputed to the corporation itself.) Thus, the court determined that the board was free to exercise its bargained-for contract right to terminate the five executive key holders and appoint Alphonso’s new interim CEO without regard to the efforts clause. By contrast, when the interim CEO terminated the non-executive key holders, the interim CEO was acting for Alphonso and had to comply with the corporation’s reasonable-efforts obligation.

Toward Whom Must Reasonable Efforts Be Used?

The court next concluded that Alphonso owes its reasonable efforts with respect to the appointment of Alphonso’s directors for the benefit of the two non-executive key holders. The efforts clause required Alphonso “to ensure that the rights granted under [the stockholders’ agreement] are effective and that the Parties enjoy the benefits of” [the stockholders’ agreement].” As parties to the stockholders’ agreement, all of the key holders were generally entitled to the benefit of Alphonso’s reasonable-efforts clause, but the efforts clause did not apply to the actions of the board.

Accordingly, when the board exercised its right to terminate the executive key holders as directors, officers and employees, only the two non-executive key holders retained the right to appoint up to three members of Alphonso’s board, subject to the conditions that they hold at least a 10 percent interest in Alphonso and that at least one of them remain an employee of the corporation. In other words, the fact that the board had the right to terminate the executive key holders without regard to the efforts clause meant that the non-executive key holders were the ultimate beneficiaries of Alphonso’s reasonable efforts. But Alphonso, through the interim CEO’s immediate termination of the employment of the non-executive key holders, denied them any opportunity to exercise their right to appoint directors, in violation of the efforts clause.

What Is Meant by ‘Reasonable Efforts’?

Noting that Delaware interprets various efforts clauses (best efforts, reasonable best efforts, reasonable efforts, commercially reasonable efforts, etc.) as having the same general meaning, the court clarified that absent a specific contractual definition, Delaware courts will interpret such provisions as creating “an affirmative obligation on the parties to take all reasonable steps.” Because this is an affirmative obligation, a party may breach an efforts clause by failing to use any efforts, i.e., by doing nothing. Beyond that, the court identified two specific factors that Delaware courts have indicated should be examined in determining whether a party has breached an efforts clause: “whether the party subject to the clause (i) had reasonable grounds to take the action it did and (ii) sought to address problems with its counterparty.”

Did the Party Bound by the Efforts Clause Act in the Manner Required?

Applying the first of the above factors, the court concluded that Alphonso had no grounds for terminating the non-executive key holders while it owed them a specific and affirmative obligation to undertake reasonable efforts to ensure their ability to appoint directors to its board. Notwithstanding that the non-executive key holders were “at will” employees of Alphonso, the court noted that the efforts clause under the stockholders’ agreement provided them a measure of employment security so that they could continue to exercise their right to appoint directors under the stockholders’ agreement: “Given that the rights were conditioned on employment, which was a condition within Alphonso’s control, Alphonso committed itself to use reasonable efforts in that regard to ensure the rights were effective.” It is particularly telling that, in contrast to the disruptive actions of the executive key holders, the non-executive key holders cooperated with Alphonso even after their termination, including volunteering to assist with knowledge transfer to other Alphonso employees.

Turning to the second factor, the court noted that Alphonso had “many less drastic alternatives to terminating the remaining Key Holders,” such as asking them to appoint new directors or negotiating with them for another resolution. The court noted that reasonable actors who are subject to an efforts clause would typically seek to discuss an issue and its potential resolution with the party to whom efforts are owed. “But here, there is not a shred of evidence demonstrating that Alphonso or [the interim CEO] gave any consideration to the [non-executive key holders’] rights, much less interacted with them in any meaningful way prior to their terminations,” the court noted.

Because Alphonso neither had reasonable grounds for the termination of the non-executive key holders nor attempted to work with them to arrive at a solution short of termination, the court held that Alphonso breached its obligations under the efforts clause. The court goes on to note that, while some discussions occurred between the executive key holders and the LG Electronics-appointed directors on Alphonso’s board, those discussions cannot satisfy Alphonso’s obligation to use reasonable efforts to protect the rights of the non-executive key holders, who were not party to those discussions.

Effect of Alphonso’s Breach of the Efforts Clause

The non-executive key holders had a right to appoint directors to Alphonso’s board so long as certain conditions were met, including the continued employment of at least one non-executive key holder. In the absence of the efforts clause, Alphonso’s termination of both non-executive key holders would have resulted in failure of the condition and would have terminated the non-executive key holders’ right to appoint directors. But the stockholders’ agreement required Alphonso to use its reasonable efforts to protect the non-executive key holders’ right to appoint directors, which limited Alphonso’s right to terminate their employment. Since Alphonso’s breach of the efforts clause caused the failure of the condition, the court held that the condition must be excused.

Referring to the “prevention doctrine” from the Restatement (Second) of Contracts, the court noted that “when a promisor’s non-performance of a contractual duty materially contributes to the non-occurrence of a condition, the condition is excused.” Applying this doctrine to the current facts, the court found that (1) Alphonso’s non-performance of its obligations under the efforts clause resulted in the termination of the non-executive key holders and (2) that termination not only contributed to, but effectively eliminated, the non-executive key holders’ right to appoint certain Alphonso directors, which was necessary to protect their liquidity rights under the stockholders’ agreement.

Accordingly, the court held that the condition that at least one key holder remain employed by Alphonso was excused, and the key holders were entitled to designate directors of Alphonso in accordance with the stockholders’ agreement, notwithstanding the termination of their employment. Because the December consent was adopted by the LG Electronics-appointed directors without the participation of directors appointed by the non-executive key holders, it was declared invalid.

What Are the Key Takeaways from the Court’s Decision?

Framework for Drafting and Interpreting Efforts Clauses

This opinion provides a helpful framework not only for interpreting efforts clauses but also for drafting them. When an efforts clause appears in an agreement, the agreement should answer at least three of the court’s questions: (1) which specific party or parties are bound by the efforts clause; (2) toward whom, or for whose benefit, must reasonable efforts be used; and (3) what reasonable steps should the party take in furtherance of the stated goal (using specific examples if possible).

When an efforts clause is interpreted, this framework expands to include a fourth inquiry — whether the party that must use reasonable efforts acted in the manner required by the obligation — which can, in turn, be answered through an examination of (1) whether the party had reasonable grounds to take the action it did and (2) whether the party sought to address problems with the party to whom the efforts obligation was owed. This framework allows counsel to provide clients with meaningful guidance as to their rights and responsibilities when asked about efforts clauses, rather than vaguely responding, “It depends.”

Distinguishing Between an Entity and the Individuals Who Act for the Entity

One key element of this decision is the distinction between Alphonso and its board of directors, each of which has different rights and obligations under the stockholders’ agreement. Such a dichotomy can arise in any agreement to which both an entity and one or more of its constituents (e.g., stockholders, directors, officers or employees) are parties, such as stockholders’ agreements, limited liability company agreements, executive employment agreements, etc. Care should be taken to clearly delineate the individuals who have authority to act on behalf of the entity under such an agreement, and that delineation should take into account both the fiduciary duties of directors, which prevent directors from delegating their rights to vote on board decisions, and potential conflicts of interest of all of the parties.

 

Meet the Author

Alycia M. Vivona

With two decades of experience in a broad-based corporate practice, Alycia Vivona has developed particular knowledge in the areas of mergers and acquisitions, cross-border representations and health care. She is chair of Stradley Ronon’s mergers & acquisitions practice and chair of its health care practice group. Alycia is adept at both translating contract language into concepts that non-lawyers can use in their decision-making and in drafting agreements that accurately document the complex business arrangements devised by her clients. Her pragmatic approach provides useful guidance to health care providers as they navigate federal and state health care laws and regulations.

avivona@stradley.com

202.419.8424

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