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Covenant Not to Sue for Loyalty Breaches in an Agreement Among Stockholders May Operate Within the Space for Fiduciary Tailoring

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July 19, 2023
By: Albert Manwaring
Delaware Business Court Insider

The fiduciary duty of loyalty may be modified or eliminated in the LLC context, where freedom of contract is paramount. For corporations governed by the Delaware General Corporation Law (DGCL), however, many Delaware practitioners understood that the duty of loyalty was sacrosanct and, unlike voting rights, appraisal rights, or the right to sell shares, could not be waived, limited, or barred in advance by parties in an agreement or otherwise. In New Enterprise Associates 14. v. Rich, C.A. No. 2022-0406-JTL (Del. Ch. May 2, 2023), the Delaware Court of Chancery ruled that a covenant not to sue for breach of fiduciary duties in connection with the exercise of a drag-along provision to approve a merger or sale contained in a voting agreement among sophisticated stockholders in a Delaware general corporation was not facially invalid.

The court emphasized that the DGCL and Delaware common law allow for a greater space for fiduciary tailoring than is commonly recognized. For example, the court noted that Section 102(b)(7) of the DGCL, exculpating directors from monetary damages for duty of care claims, and Section 122(17), allowing a corporation to renounce corporate opportunities that are presented to its directors or officers to avoid loyalty claims for usurpation of corporate opportunities, both allow for fiduciary tailoring under Delaware corporate law. Further, Section 102(a)(3) allows a corporation to tailor fiduciary duties through a limited purpose provision to control or limit actions that fiduciaries can take even if they believe such actions are in the best interest of the corporation.

The court also pointed out that contract claims preempt overlapping fiduciary duty claims and thus, following this reasoning, a contractual covenant not to sue could displace competing claims for breach of fiduciary duties. In addition, the court explained that the common law doctrine of ratification supported the validity of a covenant not to sue because the covenant operated like an advance ratification, to which stockholders had agreed in advance in connection with a drag-along provision to approve a sale or merger. Further, the court found that a stockholder, who chooses not to assert a claim in advance, was similarly situated to a stockholder facing a defense of laches, which can restrict or bar the ability to assert a fiduciary duty claim if a stockholder waits or delays too long to file a claim.

The court emphasized that stockholders should be able to enter into contracts that allow for greater constraints on their rights than a corporation could impose through its charter or bylaws. While a stockholder agreement is at the bottom of the hierarchy among the DGCL, charter, and bylaws, if the agreement does not conflict with the DGCL, charter, or bylaws, the stockholders may contract in advance to allow for private ordering, which is part of Delaware's corporate law brand.

Turning to the validity of the covenant not to sue, the court ruled that there is a two-step process to evaluate whether a provision barring the right to assert fiduciary duty claims is valid. First, the provision must be narrowly tailored to address a specific transaction that would otherwise constitute a breach of fiduciary duties. Second, the provision must survive close scrutiny for reasonableness, considering the nonexclusive factors set forth in Manti Holdings v. Authentix Acquisition, 261 A.3d 1199 (Del. 2021): “a written contract formed through actual consent, a clear provision, knowledgeable stockholders who understood the provision’s implications, the funds’ ability to reject the provision, and the presence of bargained-for consideration.” Based on these factors, the court held that the covenant not to sue was facially valid because it was bargained for by sophisticated investors, who could have rejected the covenant, to induce certain investors to provide additional funding to the company, and was narrowly tailored to apply to specific merger or sale transactions.

Ultimately, the court found here that there was a public-policy exception for intentional wrongdoing or a bad-faith breach of fiduciary duties, which prevented application of the covenant not to sue to bar fiduciary duty claims at the pleadings stage. Importantly, however, in contrast to intentional wrongdoing, the court noted that if the above two-part test is satisfied, a covenant not to sue may protect parties, who are engaged in self-interested transactions with only reckless or grossly negligent disregard for the best interests of a corporation, against claims of breach of fiduciary duties.

Delaware Business Court Insider |  July 21, 2023

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