Significant Recent Decisions Relevant To Private Company M&A – Directors and Officers

New Enterprise Associates 14, L.P. v. Rich, 295 A.3d
520 (Del. Ch. May 2, 2023)¹

Rejecting the argument in a motion to dismiss that a
covenant not to sue for breach of fiduciary duties in a stockholder
agreement that applied to drag-along transactions was facially
invalid, the Delaware Court of Chancery held that such covenants
can be legitimate forms of “fiduciary tailoring” and
provided fact-specific test for determining their
validity.

Background 

The decision (the “NEA” decision) involved a
motion to dismiss in a case brought by venture funds (the
“Funds”) challenging the drag-along sale of Fugue, Inc.
(the “Company”), a company in which they were early stage
investors. After a sale process in 2020 and early 2021 failed, the
Company raised new capital from an investor group led by defendant
George Rich (“Rich”), and a few existing investors. The
Funds did not participate. The financing transaction involved a
recapitalization of the Company in which existing preferred was
converted to common, and investors in the financing purchased
Series A-1 Preferred Stock. It was a condition to closing that all
new investors, and certain existing investors, including the Funds,
execute a voting agreement that contained a drag-along provision
and a covenant not to sue Rich or his affiliates and associates in
connection with a drag-along sale, including for breach of
fiduciary duty (the “Covenant”).

In July 2021, the Company’s board (by then consisting of
just Rich, a designee of his, and the CEO) authorized the issuance
and sale of additional shares of Series A-1 Preferred Stock to Rich
and some of the other investors through an extension of the earlier
financing. The board also authorized equity awards to management
and large equity grants to the directors.

The Company’s CEO was first contacted about a potential
acquisition in June 2021. This outreach resulted in a merger
agreement being signed and the deal closing in February 2022. In
February 2022, the Company reached out to existing investors with a
form merger agreement, notifying them of their obligation to
support the transaction under the drag-along provision by signing a
joinder agreement and a voting form. The Funds refused to sign
unless Rich and the CEO affirmed that they had not communicated
with the potential acquiror about a sale of the Company prior to
the recapitalization. In May 2022, when the affirmation was not
forthcoming, the Funds filed the lawsuit challenging the drag-along
sale and alleging breach of fiduciary duty by the directors of the
Company and Rich, as a controlling stockholder, in approving the
drag-along sale. The Funds claimed that the drag-along sale was
an interested party transaction subject to entire fairness
because it conferred a unique benefit on Rich, as controlling
stockholder, and the directors, as a result of extinguishing
derivative claims related to their self-dealing in the July 2021
Series A-1 Preferred extension and equity grants. The key issue in
the motion to dismiss was whether the Covenant barred the
Funds’ claims. 

Court’s Decision

The NEA court noted the competing considerations of
Delaware law’s pro-contractarian nature, and public policy
considerations in preserving fiduciary accountability in the
absence of express statutory authority to limit it.

The court considered the Funds’ argument that the Covenant
was facially invalid because Delaware law does not permit parties
to waive the duty of loyalty in Delaware corporations, as evidenced
by exclusion of loyalty claims from DGCL Section 102(b)(7). The
court distinguished Totta v. CCSB Financial Corp.,
² a recent decision that seemed to support the
Funds’ argument, on the basis that it dealt with a charter
provision and not a stockholder agreement. The court also
distinguished Delman v. GigAcquisitions3, LLC³
because the defendants in that case attempted to justify the
purported waiver of the duty of loyalty on public disclosure and
assumption of the risk. The NEA court held that while the
Funds’ argument for facial validity was reasonable, it ignored
the importance of private ordering through stockholder
agreements.

The NEA court undertook a detailed analysis of
arguments against facial invalidity. The court held that such a
covenant would not be facially invalid under trust or agency law.
Looking to Delaware statutory law, the court held that Section
102(b)(7) indicated that the Covenant should be valid insofar as it
dealt with waivers of direct claims for breach of the duty of care,
or for claims based on gross negligence, or recklessness. The court
also held that other DGCL provisions evidence support for fiduciary
tailoring, and undermined the argument for facial invalidity of the
Covenant, such as Section 122(17), which permits corporate
opportunity waivers, Section 102(a)(3), which permits limits on
corporate purpose, Section 141(a), which permits charter provisions
that narrow the powers and duties of the board, and Section 145,
which authorizes limitations on fiduciary accountability. The court
held that several common law doctrines also indicate that the
Covenant was not facially invalid, such as the principle that
“contractual obligations preempt overlapping fiduciary
claims,”⁴ the doctrine of advance
ratification,⁵ and the doctrine of
laches.⁶

The NEA court looked to Manti Holdings, LLC v.
Authentix Acquisition Co. ⁷ for guidance on how the
Delaware Supreme Court had treated the similar public policy issue
in the context of advance waivers of appraisal rights, also in
connection with a drag-along sale. The Manti court held
that the appraisal waivers were not facially invalid because
appraisal rights were not “sufficiently important in
regulating the balance of power between corporate
constituencies” to justify prohibiting “sophisticated and
informed stockholders” from agreeing to advance waivers of
them. The Manti court also held that the advance waivers
were not invalid under an as applied challenge given that they were
logically related to the drag-along provisions, and due to factors
such as the waivers not having been unilaterally imposed on
stockholders, the stockholders were sophisticated institutions,
there was no imbalance of information, and the stockholders
understood the implications of the waiver and gave knowing
waivers.

In light of Manti and the above considerations, the NEA court
set forth a two-part test for determining the validity of fiduciary
waivers, the first step concerning facial validity and the second
step concerning an “as applied” test. Under the first
step, “the provision must be narrowly tailored to address a
specific transaction that otherwise would constitute a breach of
fiduciary duty.” Under the second step, a court should
consider whether the waiver is “reasonable” based on
factors such as the following: “(i) the presence of the
provision in a bargained-for contract, (ii) the clarity and
specificity of the provision, (iii) the stockholder’s level of
knowledge about the provision and the surrounding circumstances,
(iv) the stockholder’s ability to foresee the consequences of
the provision, (v) the stockholder’s ability to reject the
provision, (vi) the stockholders’ level of sophistication, and
(vii) the involvement of counsel.” The court also invoked an
overriding requirement for validity that a fiduciary waiver could
not foreclose claims for intentional or bad faith breaches of
fiduciary duty. 

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Footnotes

1. https://courts.delaware.gov/Opinions/Download.aspx?id=347110

2. 2022 WL 1751741 (Del. Ch. May 3, 2022)

3. 288 A.3d 692 (Del. Ch. 2023)

4. See Nemec v. Shrader, 991 A.2d 1120, 1129
(Del. 2010)

5. See, e.g,,. In re Invs. Bancorp, Inc. S’holder
Litig., 177 A.3d 1208, 1222 (Del. 2017)

6. See, e.g., Lebanon Cnty. Empls.’ Ret. Fund V.
Collis, 287 A.3d 1160, 1194 – 95 (Del. Ch.
2022)

7. 261 A.3d 1199 (Del. 2021).

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