Many in the business law world have been following the saga involving the adoption of S.B. 313 by Delaware's General Assembly last week. S.B. 313 adds a new § 122(18) to the General Corporation Law of the State of Delaware (DGCL) that broadly authorizes corporations to enter into free-standing stockholder agreements (not embodied in the corporation's charter) that restrict or eliminate the management authority of the corporation's board of directors. See my blog posts here and here and others cited in them, as well as Ann's post here.
In the floor debate on S.B. 313 last Thursday in the Delaware State House of Representatives, a proponent of the legislation stated that fiduciary duties always trump contracts. That statement deserves some inspection in a number of respects. I offer a few simple reflections here from one, limited perspective.
The historical centrality of corporate director fiduciary duties (which were the fiduciary duties referenced on the House floor) is undeniable. Those who have taken business associations or an advanced business course with me over the years know well that I emphasize in board decision making that the directors’ actions must be both lawful and consistent with their fiduciary duties in order to be legally valid and enforceable. I doubt my teaching is exceptional in that regard.
But the floor debate involved a different kind of tangle between legal obligations and fiduciary duties than exists in the board decision-making context in which corporate action is written on a tabula rasa. The comment made in last Thursday’s legislative session responded to the suggestion that a board of directors may later decide to breach a contract that is lawful and was approved by the board in a manner that is consistent with director fiduciary duty compliance. That scenario involves board action to disregard the terms of an agreement—by authorizing and directing the corporation to breach a legal obligation of the corporation because the directors have, in good faith and with due care, determined that the breach of contract is in the best interest of the corporation.
This type of board action is certainly not unprecedented. An example from my practice immediately springs to mind: no-shop, non-solicitation, and related clauses in business combination (M&A) agreements. These provisions may be (or at least appear to be) lawful and compliant with director fiduciary duties when made but may interfere with a target board’s fiduciary duties if the board later determines it has a fiduciary obligation to engage in interactions with a potential transactional partner in violation of that type of deal protection provision.
The resolution of this issue in the M&A context has largely been contractual. Fiduciary outs of various kinds have been common in M&A agreements for decades. (I gave my first CLE talk on them back in the 1980s.) Through these provisions, directors consider and prepare in advance for the potentiality of a later conflict between the deal protection obligations of the corporation and their fiduciary duties to the corporation. Properly drafted, fiduciary outs help protect the legal validity and enforceability of the original contract from future challenge and preserve the board’s legal right to respond to new circumstances without breaching the contract.
As those who work in this space well know, a watershed case involving deal protection provisions is Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914 (Del. 2003). In its Omnicare opinion, the Delaware Supreme Court assesses the validity of a merger agreement that effectively locked up a majority of the votes needed to approve the merger. The merger agreement did not include a fiduciary out provision. The directors had no ability to terminate the merger agreement or nullify its terms to comply with their fiduciary duties without breaching the contract. The court found the deal protections invalid and unenforceable.
Proponents of S.B. 313 clearly state that a corporation's exercise of its authority to enter into stockholder agreements under § 122(18) will be subject to challenge if the directors breach their fiduciary duties to the corporation in approving a stockholder agreement or in later authorizing the corporation's performance under that agreement. If the corporation's directors are found to be in breach, the stockholder agreement then may be found invalid or unenforceable. The prospect of that occurring in the stockholder agreement context is as real as it is in the M&A deal protection context.
Perhaps, then, fiduciary outs are a best practice that should grow out of the new DGCL § 122(18). If the parties truly intend for fiduciary duties to trump the contract (as the bill proponents have claimed) and we can anticipate challenges in that regard based on the nature of the agreement, stockholder agreements should provide in advance for the eventuality of a conflict. Otherwise, a stockholder agreement authorized under DGCL § 122(18) may be found either invalid ex post because the board’s original approval of the agreement may later be determined to have been a breach of the directors’ fiduciary duties (for failure to include a fiduciary out, as in Omnicare) or unenforceable in litigation over a board decision to breach or refrain from breaching the agreement in the face of a perceived fiduciary duty conundrum related to the corporation’s performance under the terms of the agreement. A well-crafted fiduciary out (which would undoubtedly be somewhat bespoke, as it should be in the M&A context, based on the nature of the corporation’s obligations in the contract) should help avoid litigation, or at least enable its early dismissal, in the event of either type of legal claim.
Your reactions to these musings are, as always, welcomed. We will be operating in new territory here assuming the Governor of Delaware signs S.B. 313 into law (as he has signaled). If I am missing an element of statutory or decisional law or strategic litigation practice that impacts my arguments, I would appreciate hearing about it. Regardless, it is now time that we all think about how to address anticipated issues arising from the Pandora’s box that the Delaware General Assembly has opened. That may include practice-oriented solutions to perceived legal questions or tensions as well as potential further adjustments to the DGCL. As to the latter, I note that I raised in one of my earlier posts the desirability of looking at DGCL subchapter XIV in light of the provisions of DGCL § 122(18). Perhaps that issue merits a subsequent post . . . .