Vice Chancellor J. Travis Laster of the Delaware Court of Chancery recently ruled on whether a covenant not to sue set out in a shareholders agreement is enforceable under Delaware law, which would prevent a shareholder from contesting a sale of the company. Such clauses have become increasingly common among private companies, and the clause in this case was based on a National Venture Capital Association form.
The court found that, generally, such recognizances not to sue are enforceable under Delaware law, but that the circumstances in a particular case will matter and such recognizances cannot protect counsel. administration and other defendants from any liability for intentionally harmful conduct. In that case, the court determined that because the underlying allegations could support claims of willful misconduct on the part of the board of directors and a controlling shareholder, the covenant not to sue could not serve as a basis for dismissing claims.
Context of the decision
The case arose out of a 2022 sale of a private company and involved the following set of facts, taken from the complaint. Prior to the completion of the sale, the company needed financing, but appeared to have limited options, either for financing or a liquidity event. The company therefore undertook a financing round and recapitalization, under which certain investors purchased new preferred shares of the company, all existing preferred shares were converted into ordinary shares and certain existing shareholders (including the plaintiffs in this case) have signed a shareholders’ agreement. containing a drag-out clause and the relevant covenant not to sue. Two independent directors subsequently resigned, leaving the board with only two directors affiliated with the lead investor and the company’s chairman and CEO. Once the round was over, the board members granted themselves stock options, which would later result in a 3,200% return on the sale of the company. Shortly after the round closed, the company received an unexpected request from the buyer in this deal to acquire the company for $120 million. Following receipt of this request, insiders obtained shareholder approval to extend the previous round and issued additional shares, including to themselves, but did not disclose the possibility of the sale to shareholders. Selling the business ultimately gave round and expansion participants a nearly 750% return on investment.
The plaintiffs in this case, well-known venture capitalists, learned the full extent of the facts by bringing a request for books and records. The plaintiffs later filed a lawsuit against the board of directors and the principal investor, alleging that the directors and the investor, as majority shareholder, breached their fiduciary duties under the sale of the company and previous transactions. In an earlier decision in the litigation, the court ruled that the claims properly allege a breach of fiduciary duty. In that case, the issue was whether the recognizance not to sue – to which the plaintiffs had consented – would serve as a separate defense to dismiss the claims.
The covenant not to sue was set forth in a customary ripple provision in a shareholders agreement, which provided that if specific board and shareholder approvals were obtained, the signing shareholders agreed to take various actions. in support of the transaction, including voting in favor of the transaction. The covenant not to sue itself provided, in its relevant part, that each signing shareholder would refrain from exercising their rights of expertise or “from asserting any claim or from taking legal action” contesting a sale of the company or the shareholders’ agreement or “alleging a breach of any fiduciary duty…in connection with the evaluation, negotiation or conclusion of a sale of the company or the realization of a sale, but only if the transaction met certain requirements specified in the shareholders’ agreement.
The Court’s findings
The court spent most of its 129-page opinion reviewing various strains of Delaware law and academic commentary to determine whether such a recognizance not to sue is apparently valid under Delaware law. The court decided it did, finding that, as a whole, Delaware law permits the kind of private order and adaptive fiduciary behavior reflected in such an undertaking, when set forth in a shareholder agreement. Among other things, the court pointed to various aspects of Delaware’s corporate law permitting private orders, a recent Delaware Supreme Court decision upholding a knowledgeable shareholder’s waiver of appraisal rights in a shareholders’ agreement. similar and the ability under Delaware law to waive constitutional and other important rights. The court in turn rejected plaintiffs’ argument that Delaware corporations, unlike alternative entities such as LLCs, involve unalterable rules relating to fiduciary conduct, particularly the duty of loyalty involved in this affair.
Beyond face validity, however, the court found that in each given case in which a recognizance not to sue is invoked, the Delaware courts will consider the particular facts to determine whether the recognizance should be enforceable. For one thing, the covenant not to sue “must be narrowly tailored to address a specific transaction that would otherwise constitute a breach of fiduciary duty.” The court determined that this requirement was met in this case, since the drive in question, as is common, related to particular types of sales which would receive certain approvals from the board of directors and shareholders and had to meet to certain requirements. Additionally, the court held that the facts in a given case must support a conclusion that the recognizance is reasonable as applied, taking into account factors such as the existence of a written contract formed by consent membership, a clearly stated commitment, “knowledgeable shareholders who understand the implications of the disposition,” an ability to reject the disposition, and the presence of negotiated consideration. The court concluded that these requirements were met in this case, particularly given the sophistication of the claimants. Under different circumstances, according to the court, a “proponent of a provision like the (c)ovenant would face deep skepticism and an arduous climb”.
Nevertheless, the court ultimately determined that the recognizance not to sue would not serve as a basis for dismissing the claims in this case. Citing Delaware public policy, the court ruled that a contract term cannot exempt defendants from tort liability — including claims of fiduciary duty — when they intentionally cause harm. The court found that the allegations suggested the possibility of such conduct here and would not be prevented by the recognizance not to prosecute. On the other hand, if litigation ultimately shows that “defendants engaged in transactions for their own benefit but believed in good faith that the transactions were not contrary to the Company’s best interests, then the (c )ovenant excludes such claims”.
Take away food
Given the court’s finding that do not sue clauses are generally enforceable under Delaware law, we will continue, pending any appeal in the case, to see their inclusion in shareholder agreements. and drag-out clauses with the aim of mitigating shareholder disputes that could impede a sale of the business in the future, and the market can continue to innovate within the parameters described in this case. That said, the case, along with other recent Delaware case law, indicates that Delaware courts will consider such clauses on a case-by-case basis, taking into account how the clause is worded, who the shareholder is applicant and the circumstances. in the case. The case also supports the proposition, again consistent with other Delaware decisions, that if a breach of fiduciary duty is serious enough, a recognizance not to sue and a knock-out provision cannot preclude a claim.
In light of these considerations, in any particular transaction, parties should consider whether the use of a drag-out clause and the use of a covenant not to sue is desirable. For additional discussion on this topic, please see our previous Customer Alert: https://www.wsgr.com/en/insights/how-to-navigate-the-decision-of-exercising-drag-along-rights-during-an-manda-process.html.
Beyond the enforceability of a covenant not to sue, the case serves as a reminder that shareholder disputes can and do arise over private company mergers and acquisitions and other transactions involving private companies and that such disputes may be difficult to dismiss given the potential conflicts of interest and facts that may exist in the context of private enterprise. Boards of private companies undertaking a sale process should understand that Delaware courts focus on the process, for example, the existence and role of independent directors, the quality of disclosure to shareholders, the appropriate use of outside advisors, the directors’ understanding of their fiduciary duties and whether the directors negotiated for the benefit of disinterested shareholders. The board should, therefore, work with counsel to design a deliberative process that, while practical, protects the board and other defendants as much as possible from shareholder litigation should litigation arise.
1New entry. Assoc. 14, LP vs. RichCA No. 2022-0406-JTL.(flip)
2New entry. Assoc. 14, LP vs. Rich2023 WL 2417271 (Del. Ch. 9 Mar. 2023).(flip)
3Manti Holdings, LLC v Authentix Acquisition Co.261 A.3d 1199 (Del. 2021).(flip)