KEY TAKEAWAYS:

• Delaware General Corporation Law (“DGCL”) permits limited “tailoring” of fiduciary duties in contractual covenants (such as covenants not to sue)
• A covenant not to sue contained in a drag along provision of a stockholder voting agreement may be enforceable against sophisticated stockholders if specific and reasonable
• Such covenants may be unenforceable in certain circumstances, such as where there are countervailing public policy considerations, or against certain types of stockholders, such as employees who receive incentive equity

In a recent case decided on May 2, 2023, New Enterprise Associates 14, L.P. v. Rich, the Delaware Court of Chancery concluded that a contractual covenant of certain stockholders not to sue in connection with a sale of the corporation can be enforceable under certain circumstances. The covenant in question in Rich was contained in a voting agreement between stockholders in which certain stockholders agreed not to bring suit in connection with another stockholder’s exercise of its right to force a sale of the corporation. The plaintiff stockholders asserted that the majority stockholder and the directors of the corporation breached their fiduciary duty of loyalty by engaging in the contractually authorized transaction. The Court, however, found that Delaware law (including Sections 102(b)(7) and 122(7) of the DGCL) does permit limited tailoring of fiduciary duties under certain circumstances.

The Court noted that the two crucial factors in determining whether such covenants can be enforceable are the level of specificity of the provision and its reasonableness. In regards to specificity, the Court emphasized that “the level of specificity must compare favorably with what would pass muster for advance authorization in a trust or agency agreement…”; otherwise the provision will be found to be facially invalid. The covenant in Rich was found to be specific enough to be valid because it only covered transactions which (i) fell into one of the three enumerated transactions that qualified as a sale of the corporation and (ii) included terms that met eight specific criteria to qualify as a drag along sale. In regards to reasonableness, the Court stated that factors that would favor a covenant being considered reasonable include: (i) a written contract formed through actual consent, (ii) a clear provision, (iii) knowledgeable, sophisticated stockholders who understood the provision’s implications, (iv) the ability of other stockholders to reject the provision, and (v) the presence of bargained-for consideration. The facts of Rich fell in line with the factors stated above and thus the Court was comfortable in finding that the covenant was enforceable as a threshold matter. Ultimately, however, the Court applied a public policy limitation to deny a motion to dismiss, holding that the covenant not to sue could support a claim involving tort liability based on intentional misconduct.

The Court also noted specific situations where a covenant like the one in Rich “would face deep skepticism and a steep uphill slog” when brought before the Court, including an agreement binding a retail stockholder, an employee stock grant, a dividend reinvestment plan, an employee stock compensation plan, a stock transmittal letter, and a transaction that offered an election between base consideration and incremental consideration plus a covenant not to sue.

Thus, the key takeaway from the Court’s ruling in Rich is that individuals or entities who want to tailor fiduciary duties by including covenants not to sue in contractual drag along provisions need to ensure they adhere to very specific criteria when including such a covenant in their agreements. It is also important to make sure all of the parties are well aware of what they are agreeing to, that the contract is formed with full consent of the parties, and that the provision is very clear. As noted by the Court, these type of covenants are likely not enforceable in connection with the grant of incentive equity to employees, a circumstance that is contemplated by and common when utilizing NVCA-style voting agreements. It is important to note that the holding of the Rich case addressed the enforceability of the covenant not to sue, and not the enforceability of the drag along provision itself.

This article is not meant to be an exhaustive description of all aspects of waiving or tailoring corporate fiduciary duties under Delaware law. If you would like to further discuss the holding in Rich and its potential implications in the corporate transactional space, please contact the authors.