In the recent case New Enterprise Associates 14, L.P. et al. v. Rich et al., the Delaware Court of Chancery denied the defendants’ motion to dismiss a breach of fiduciary duty claim notwithstanding that the plaintiffs had previously agreed not to sue the defendants based on the precise claim at issue. The plaintiffs, minority investors in a Delaware corporation, had signed a voting agreement under which the defendants agreed not to sue the majority – including for breach of fiduciary duties – if the majority proceeded with a drag-along sale that satisfied certain requirements.
The court characterized its decision as “grapp[ling] with a conflict between two elemental forces of Delaware corporate law: private ordering and fiduciary accountability.” Private ordering, which is based on “the contractarian nature of Delaware corporate law,” refers to restrictions on the exercise of stockholder rights that are imposed by a corporation’s charter and bylaws or by a stockholder agreement. By contrast, fiduciary accountability refers to the fiduciary duties that may be tailored but not waived under Delaware law. The court noted that while fiduciary duties and private ordering ordinarily operate in harmony, they pulled in opposite directions in this case, requiring the court to reconcile the conflict. Ultimately, the court concluded that as a matter of public policy, private ordering could not shield defendants from liability for intentional breaches of fiduciary duties, such as bad faith. Accordingly, the court held that the plaintiffs could prevail – notwithstanding their covenant not to sue – if the plaintiffs are able to prove that the defendants’ breaches of fiduciary duty constituted intentional harm. In light of this narrow avenue for the plaintiffs’ possible success on the merits, the defendants’ motion to dismiss was denied.
This decision could have significant consequences for companies that rely on drag-along provisions, fiduciary duty waivers and/or covenants not to sue that appear in letters of transmittal, employee stock grants or other documents that could be viewed as imposing these restrictions on less sophisticated investors.
The plaintiffs were investment funds that held a minority interest in Fugue, Inc., a startup that found itself in desperate need of capital. Following an unsuccessful sale process, Fugue agreed to a recapitalization in which the defendants purchased shares of Fugue’s preferred stock that carried powerful management rights. In connection with the recapitalization, Fugue and most of its stockholders entered into a voting agreement based on the National Venture Capital Association’s model form. The voting agreement contained (i) a drag-along provision that obligated the signatory stockholders to support a sale of Fugue if the sale was approved by the board of directors and a majority of the preferred stockholders and (ii) a covenant not to sue the directors or their affiliates in connection with a sale of the company that met the requirements of the drag-along provision.
Three months after the recapitalization, when Fugue was no longer in severe financial distress and had received an expression of interest from a potential acquirer, Fugue’s new board of directors approved an “amendment” to the recapitalization pursuant to which certain preferred stockholders, including the defendants, purchased additional Fugue shares at the same distressed price as in the original recapitalization. Additionally (as described in more detail in the court’s companion opinion issued March 9), the directors granted themselves millions of options with a strike price set at one-tenth of the value of the common stock implied by the recapitalization. When the sale of Fugue closed, the preferred stockholders received consideration reflecting a return of almost 750%, while the option holders received a return of 3,200%. These returns came at the expense of Fugue’s original investors, prompting those original investors to sue the defendants for breach of their fiduciary duties. The defendants argued that the claims based on the sale must be dismissed since the sale satisfied the requirements of the drag-along provision in the voting agreement under which the plaintiffs had agreed not to sue for such claims.
The Court’s Decision
The court noted initially that the plaintiffs had argued neither that the covenant not to sue was ambiguous nor that it was induced by fraud or overreaching by the defendants. Rather, the plaintiffs relied on the “short and sweet” argument that the covenant not to sue was facially invalid simply because “[u]nder well-settled law, parties cannot waive fiduciary duties of loyalty in Delaware corporations.” Examining this argument in detail, the court proceeded to distinguish each statutory provision and case law precedent cited in support of the plaintiffs’ position, concluding that:
- The [plaintiffs] have advanced one reasonable interpretation of the law, but it is a stark account that elevates fiduciary accountability above all else, fails to explore the permissible bounds of fiduciary tailoring and ignores the difference between limitations in the constitutive documents of an entity and limitations in a stockholder-level agreement. The [plaintiffs’] absolutist framing pays no heed to the importance of private ordering, which is another fundament of Delaware entity law.
Turning to the arguments in favor of enforcing the covenant not to sue, the court began by examining fiduciary tailoring in the contexts of trust law and agency law, under which the court determined that the covenant not to sue would be upheld. Expanding its analysis to Delaware corporate law, the court found support for the tailoring of fiduciary duties and the validity of covenants not to sue in various sections of the Delaware General Corporation Law – including notably Section 102(b)(7) regarding exculpation, Section 141(a) regarding limits on board authority and Section 145 regarding indemnification and insurance. The court also found support for the enforceability of the covenant not to sue in the common law doctrines of contractual preemption of fiduciary claims and advance ratification of interested transactions as well as in the equitable doctrine of laches. Finally, the court noted that the enforceability of a limitation on stockholder rights is greatest when the limitation appears in a stockholder agreement rather than in the corporate charter or bylaws. These considerations supported the court’s determination that the covenant not to sue falls within the realm of private ordering and is not facially invalid as a waiver of the defendants’ fiduciary duties. The court then quickly dispatched three additional arguments against enforcing the covenant, concluding that (i) the right to sue for breach of fiduciary duty is not “too big” to waive, (ii) enforcing a provision like the covenant not to sue does not threaten Delaware’s corporate brand and (iii) upholding a provision like the covenant not to sue does not collapse the distinction between corporations and limited liability companies.
Having determined that the covenant not to sue was not facially invalid, the court turned to the Delaware Supreme Court’s decision in Manti Holdings, LLC v. Authentix Acquisition Co., 261 A.3d 1199 (Del. 2021) and the Chancery Court’s decision in In re Altor Bioscience Corp., C.A. No. 2017-0466-JRS (Del. Ch. May 15, 2019), which required the court to look beyond the facial validity of the covenant not to sue to determine whether it was valid as applied. Based on these cases, the court developed a two-part analysis. The first part requires that the provision be narrowly tailored to address a specific transaction that otherwise would constitute a breach of fiduciary duty – “If the provision is not sufficiently specific, then it is facially invalid.” The covenant not to sue in the instant case satisfied this requirement because it applied only to drag-along transactions meeting a specific list of criteria. The second part of the analysis requires the provision to survive close scrutiny for reasonableness. In deciding that the covenant not to sue was in fact reasonable, the court pointed to the following non-exclusive factors: “(i) a written contract formed through actual consent, (ii) a clear provision, (iii) knowledgeable stockholders who understood the provision’s implications, (iv) the [plaintiffs’] ability to reject the provision and (v) the presence of bargained-for consideration.” By contrast, the court identified several scenarios where a claim of reasonableness of a fiduciary duty waiver or covenant not to sue would face “deep skepticism and a steep uphill slog,” including an agreement binding a retail stockholder, an employee stock grant, a dividend reinvestment plan, an employee stock compensation plan and a stock transmittal letter.
After determining that Delaware corporate law regarding fiduciary tailoring and private ordering permits the enforceability of a covenant not to sue for breach of fiduciary duties so long as the covenant is sufficiently specific and its application survives the court’s strict scrutiny for reasonableness, the court appeared ready to grant the defendants’ motion to dismiss. But one final consideration caused the court to decide for the plaintiffs. Citing the Restatement (Second) of Contracts §195, the court noted that a contract term that would exempt a party from tort liability for harm caused intentionally by the party is unenforceable on the grounds of public policy. Further noting that a claim for breach of fiduciary duty is an equitable tort, the court held that, “To the extent the [covenant not to sue] seeks to prevent the [plaintiffs] from asserting a claim for an intentional breach of fiduciary duty, then the [c]ovenant is invalid – not as an impermissible form of fiduciary tailoring, but because of policy limitations on contracting.” Thus, the plaintiffs’ agreement not to sue the defendants in connection with the drag-along sale would be enforceable, notwithstanding the defendants’ receiving an outsized share of the sale consideration, unless the plaintiffs could prove that the harm to them was intentional. If the defendants acted in good faith or even with reckless disregard for the best interests of the company, then the covenant not to sue would protect them.
Takeaways and Practice Pointers
The court rejected the argument that a waiver of duties of corporate fiduciaries is invalid on its face. It affirmed that Delaware corporate law generally permits tailoring of fiduciary duties and that private ordering through stockholder agreements among sophisticated investors will generally be enforceable if the provisions are specific and reasonable, but the court drew the line at covenants not to sue for bad faith or other intentional harm. The covenant not to sue for fiduciary duty breach at issue in this case might be unenforceable if plaintiffs can prove intentional harm, but absent such proof, the plaintiffs’ covenant not to sue for defendants’ breaches of corporate fiduciary duties would be enforceable.
This case reinforces the following practice pointers:
- Waivers of fiduciary duties, including covenants not to sue, must be drafted clearly and unambiguously.
- The waiver should relate to a specific transaction or a narrowly defined subset of transactions; an overly broad scope risks unenforceability.
- Waivers of fiduciary duties and covenants not to sue may only be upheld against sophisticated investors who are represented by counsel, and clients should be alerted to the potential difficulty of enforcing such provisions against employee option holders or less sophisticated stockholders in a company sale.
- Similarly, caution should be used when relying on fiduciary duty waivers or covenants not to sue when such provisions appear in plans or documents that are presented to investors as non-negotiable.
- Effective private ordering should be in exchange for valuable consideration and part of a bargained-for exchange.
- Limits on stockholder rights, such as waivers of fiduciary duties and covenants not to sue, will not protect clients from liability for bad faith or other intentional harm.
Meet the Authors:
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.