Fiduciary Tailoring and the Limits of Advance Waivers under Delaware Law

On May 2, 2023, in New Enterprise Associates 14, L.P., et al v. Rich, et al.¹, the Delaware Court of Chancery clarified the scope and limits of stockholders’ ability to provide an advance waiver of their right to sue for breach of fiduciary duty under the Delaware General Corporation Law (the “DGCL”). The court held that stockholders of a Delaware corporation may waive fiduciary duty claims in advance if the waiver passes scrutiny under the court’s articulated two-pronged test. But that does not end the inquiry—the waiver must also be enforceable as applied. A waiver that seeks to immunize a party from liability for its own fraud or bad faith is not enforceable as applied. The NEA opinion provides valuable guidance for parties considering advance fiduciary duty waivers. The opinion also further confirms that a properly drafted drag-along provision² is enforceable under the DGCL and an effective contracting tool for private parties in corporate transactions.

Facts

The NEA case arose from a dispute about the financing and later sale of a privately-held cloud infrastructure company (the “Company”). The principal plaintiffs were Core Capital Partners III, L.P. (“Core Capital”) and New Enterprise Associates 14, L.P. and their respective affiliate funds (“NEA”), venture capital funds that had invested in the Company through several rounds of equity financing. The principal defendants were George S. Rich Sr. (“Rich”), David Rutchik (“Rutchik”) and Josh Stella (“Stella”), comprising all directors of the Company during the relevant period, plus investors that participated in later financing rounds, including entities affiliated with Rich and Rutchik.

The Company was founded in 2012, with Stella as its Chief Executive Officer. Core Capital invested in 2013 in a series seed preferred stock financing. NEA followed in a subsequent round of equity funding in 2014. In the ensuing years, these funds and their affiliates invested approximately US$40 million in the Company in the form of preferred equity. The financing rounds and the terms of the preferred stock were customary for venture capital transactions. Each of the funds had the right to (and did) appoint one member of the Company’s board of directors.

In 2020, at the funds’ urging, Stella unsuccessfully sought a buyer for the Company. In the first quarter of 2021, the Company pivoted to identifying other sources of capital. The plaintiffs were unwilling to provide additional funding. Stella ultimately identified Rich and his investor group, who were willing to provide US$8 million of new equity capital as a part of a recapitalization transaction.³ Under the terms of the transaction, all outstanding preferred stock would convert into common stock, thereby stripping all preferred holders of their rights, preferences, and privileges. A condition to the recapitalization was that the Company’s significant stockholders sign a voting agreement (the “Voting Agreement”). The Voting Agreement stripped the plaintiffs of their pre-existing board appointment rights and mandated that the parties vote their shares to appoint five directors, each of whom would be designated by a specified group of stockholders. As the lead investor, Rich negotiated that one of the five board seats would be designated by his investing entities.

The Voting Agreement also included a drag-along provision that, in simplified terms, required the signatories to vote in favor of a future sale of the Company that met certain criteria, take specified actions to facilitate such a transaction, agree not to oppose such a transaction, and covenant not to sue Rich or his affiliates over such a transaction. The covenant not to sue (the “Disputed Covenant”) barred the signatories from asserting claims for breach of fiduciary duty. Under the terms of the Voting Agreement, the drag-along could be invoked if the Company’s board of directors and holders of a majority of the outstanding preferred stock approved the proposed transaction.

As part of the recapitalization, the Company offered existing stockholders the ability to participate by purchasing the new preferred securities. While several existing stockholders and employees participated, the plaintiffs declined. Since no other financing or sale transactions were presented, the Company’s board approved the recapitalization as did the requisite number of stockholders under the Company’s certificate of incorporation and stockholder agreements. The directors designated by plaintiffs and the plaintiffs themselves all voted to approve the transaction, and it closed in April 2021.

In June 2021, a third party contacted Stella about a potential acquisition of the Company. A month later, the Company’s two independent board members resigned, leaving a board of only three: Stella, Rich, and Rutchik, the last of whom had joined as a designee of the holders of a majority of the preferred stock.⁴ Later that month, the Company consummated two sets of equity transactions. First, the Company sold a significant amount of additional shares of the same type of preferred stock issued in the April 2021 recapitalization to various investors, including the Rich-affiliated and Rutchik-affiliated entities, at the same valuation as the April 2021 valuation. As the court noted, this transaction “enabled the buyers to acquire shares at the same price and on the same terms that Rich had extracted in April 2021 when the Company was low on cash and had no alternatives [i.e., before the June 2021 third party acquisition inquiry].”⁵ Second, the board approved grants of stock options, including significant grants for each of the three directors. The court referred to these two sets of transactions as the “Interested Transactions.”

In December 2021, the Company reached an agreement in principle to be acquired in a merger for US$120 million, a significant premium to the Company’s valuation at the time of the recapitalization (the “Merger”). The board and stockholders sufficient to invoke the Voting Agreement’s drag-along provision approved the Merger. In February 2022, the Company delivered to its stockholders, including the plaintiffs, the merger agreement along with voting and joinder agreements consistent with the drag-along provision. The voting and joinder agreements required the stockholders to vote in favor of the Merger, refrain from opposing the Merger, agree not to sue any of the parties to the Merger or other parties with an interest in the Merger, and agree to be bound by the indemnification obligations in the merger agreement. The plaintiffs refused to sign the voting and joinder agreements. The Company therefore exercised the drag-along provision, executed the joinder and voting agreements on behalf of the plaintiffs, and closed the Merger.

On May 9, 2022, the plaintiffs filed an eight-count complaint. Count VI alleged that Rich, Rutchik, and Stella breached their fiduciary duties of loyalty as directors by approving the Merger. Court VII alleged that the Rich-affiliated investors in the recapitalization became controlling stockholders following the recapitalization and breached their fiduciary duties as controlling stockholders by approving the Merger. Count VIII alleged that the Rutchik-affiliated investing entities aided and abetted these fiduciary duty breaches. The complaint linked the Merger approval with the Interested Transactions by asserting that the Merger “failed to provide any consideration for derivative claims relating to the Interested Transactions” and that the consummation of the Merger “conferred a unique benefit on Rich, Rutchik, Stella and their affiliates by extinguishing the standing of sell-side stockholders to pursue those [derivative] claims.”⁶ Because of the connection between the Merger and the Interested Transactions, the plaintiffs alleged that, notwithstanding the unaffiliated third party buyer, the Merger was an interested transaction that required the court to evaluate the board’s (and alleged controlling stockholder’s) conduct under the entire fairness standard rather than the deferential business judgment rule.⁷ Defendants moved to dismiss the claims.

Court’s Analysis

The Court of Chancery succinctly articulated the core issues before it: “This decision grapples with a conflict between two elemental forces of Delaware law: private ordering and fiduciary accountability. Ordinarily, those forces operate harmoniously. Here, they pull in opposite directions.”⁸ How far can stockholders go to contract around the baseline protections afforded to the stockholders of a Delaware corporation under the DGCL? Are there limits to stockholders’ ability to contract around the DGCL? After comprehensively analyzing these questions, the court concluded that, while the DGCL provides significant freedom of contract, this freedom is not absolute, particularly with respect to claims of breach of fiduciary duty alleging tort-based intentional harm. In such an instance, Delaware public policy overrides a blanket rule allowing for unlimited private contracting.

To proceed with their breach of fiduciary duty claims, the plaintiff funds had to overcome defendants’ threshold argument that plaintiffs had explicitly waived their rights to bring such claims in the Voting Agreement. This required plaintiffs to show that the Disputed Covenant was not valid or enforceable. The plaintiffs asserted that, because fiduciary duties are creatures of equity, there can be no limits on such duties except to the extent the DGCL specifically authorizes them, and the DGCL does not authorize a provision like the Disputed Covenant. The plaintiffs also asserted that the covenant was unenforceable as contrary to Delaware public policy. Defendants countered with what the court called a “fiduciary tailoring” argument, which is the notion that fiduciary duties can be tailored or waived in advance by private agreement, even without specific authorization under the DGCL.

To resolve the dispute, the court examined various provisions of the DGCL⁹ as well as other legal regimes under Delaware law, including the trustee-beneficiary and agent-principal relationships. In each instance, the court identified precedent supporting the defendants’ position that Delaware statutory and common law allow for fiduciary tailoring to varying degrees. The court also noted the DGCL’s strong bias in favor of allowing contracting parties to freely allocate rights and restrictions among themselves: “When parties have ordered their affairs voluntarily through a binding contract, Delaware law is strongly inclined to respect their agreement, and will only interfere upon a strong showing that dishonoring the contract is required to vindicate a public policy interest even stronger than freedom of contract.”¹⁰ The court therefore concluded that fiduciary tailoring, or the advanced waiver of claims, is permissible under the DGCL. But within what limits?

To answer that question, the court turned to relatively recent Delaware decisions. First, the court relied heavily on the analytical framework in Manti Holdings, LLC v. Authentix Acquisition Co.¹¹ In Manti, the Delaware Supreme Court considered whether a sophisticated stockholder could waive in advance its right to exercise its appraisal rights under the DGCL in connection with a sale of a Delaware corporation. The court considered the policy favoring freedom of contract, the principle that parties can waive mandatory rights, and the absence of any prohibition against appraisal rights waivers in the DGCL. The court concluded that, despite the importance of appraisal rights, stockholders could waive those rights in advance as contemplated in customary drag-along provisions in stockholders’ agreements. But the court’s conclusion was not a blank check for such waivers. Context mattered. The plaintiffs were “sophisticated investors, represented by legal counsel, that agreed to a clear waiver . . . in exchange for valuable consideration.”¹² The stockholders’ agreement was not a contract of adhesion, nor was there coercion. The plaintiffs knew what they were agreeing to waive and could predict the circumstances in which the drag-along might be exercised. The plaintiffs were not “retail investors.” They were insiders who were involved in the negotiation of the stockholders’ agreement and therefore not at an informational disadvantage relative to the defendants. The court concluded that the drag-along’s advance waiver of appraisal rights was enforceable under the facts before it. The court nonetheless cautioned that “there are other contexts where an ex ante waiver of appraisal rights would be unenforceable for public policy reasons.”¹³

The court in NEA applied the Manti framework and likewise concluded that the waiver as written did not exceed the limits on advanced waiver of fiduciary duties. The plaintiffs in NEA were sophisticated investors represented by legal counsel in connection with the negotiation of the recapitalization and the Voting Agreement. They approved the recapitalization and the Voting Agreement, and their board representatives voted in favor of and approved the transaction. The plaintiffs knew about the Disputed Covenant and how it might be used against them in a future Company sale transaction. The plaintiffs were insiders and, therefore, not at an informational disadvantage relative to the defendants. There was no coercion because the plaintiffs could have vetoed the transaction but chose not to: “If they did not like the Recapitalization, [the plaintiff funds] could have blocked it, forced the Company to seek different terms, or funded the Company themselves. If they saw no alternative but thought Rich had secured a great deal, then they could have joined the investor group [by investing more].”¹⁴ The court noted that one of the plaintiffs was a member of the National Venture Capital Association (the “NVCA”) and that the Disputed Covenant tracked the drag-along language in the NVCA’s model agreements.

The court in NEA also relied on the decision In re Altor Biosciences Corp.¹⁵ There, the Court of Chancery upheld a covenant not to sue¹⁶ for breach of fiduciary duty in connection with the sale of a privately held Delaware corporation, Altor Biosciences, Inc. As in NEA, the plaintiff stockholders in Altor Biosciences sued the company’s board of directors for breach of fiduciary despite the plaintiffs’ prior execution of a covenant not to sue. The court in NEA focused on one specific point in the Altor Biosciences opinion: the waiver of claims by the plaintiffs did not eliminate the fiduciary obligations (and therefore liability) of the Altor Biosciences board because “there were other stockholders who could sue [the Altor board].”¹⁷ Because only two stockholders had agreed not to sue the board for breach of fiduciary duty, the court found that the board was still sufficiently accountable, since a meaningful portion of the Altor Biosciences stockholder base retained the right to sue and could therefore provide meaningful board oversight.

Holding

Based on this analysis, the Court of Chancery concluded that the “as written” validity of an advance waiver of equitable claims such as the Disputed Covenant should be evaluated under a test that requires answering two questions. First, was the advance waiver “narrowly tailored to address a specific transaction or specific type of transaction that would otherwise constitute a breach of fiduciary duty?”¹⁸ Second, was the disputed provision reasonable? The court identified several non-exclusive factors to evaluate the reasonableness of such a waiver, including the factors addressed in Manti and Altor Biosciences. An advance waiver that fails to satisfy both prongs would be invalid. The court evaluated the Disputed Covenant and circumstances surrounding plaintiffs’ entry into the Voting Agreement and determined that the advance waiver met both prongs and was therefore valid as written.

Despite this conclusion, the court ruled in favor of the plaintiffs. So what happened? “Bad facts.” The court concluded that the complaint alleged sufficient “bad facts” about the Interested Transactions and the timing of those transactions relative to the recapitalization and the Merger to call into question the enforceability of the waiver. The court instructed that even if a waiver is valid as written, it must also be properly enforced (or valid “as applied”). Generally,¹⁹ an advance waiver like the Disputed Covenant cannot immunize an enforcing party from liability for that party’s future intentional tort: “Even if a contract purports to give a general exoneration from ‘damages,’ it will not protect a party from a claim involving its own fraud or bad faith.”²⁰ As the court explained, “[t]o the extent the [Disputed Covenant] seeks to prevent the funds from asserting a claim for an intentional breach of fiduciary duty, then the [Disputed Covenant] is invalid—not as an impermissible form of fiduciary tailoring but because of policy limitations on contracting.”²¹ Because the court previously concluded²² that the facts as alleged could support a reasonable inference of bad faith breach of fiduciary duty regarding the Interested Transactions, the court denied the defendants’ motion to dismiss.

Key Takeaways

The NEA decision provides helpful guidance for companies, their boards, and their stockholders with respect to common drag-along provisions. Fundamentally, the opinion:

• reinforces the Delaware Court of Chancery’s continued willingness to uphold properly drafted drag-along provisions of the type typically found in venture capital and private equity transactions, including the provision in the NVCA form.

• affirms the ability of parties in corporate and commercial transactions to waive in advance breach of fiduciary duty and other important equitable claims.

• guides parties contemplating implementing fiduciary duty waivers in corporate and commercial transactions by articulating a two-pronged test for enforceability, requiring waivers to be valid both as written and as applied, and warning that a waiver cannot insulate an enforcing party from its own intentional tort.

However, the NEA decision may also bring increased scrutiny to some common practices and provisions with respect to voting agreements for stockholders of Delaware corporations in corporate transactions, such as:

• the enforceability of drag-along provisions on “retail investors,” who are neither venture capital investors nor institutional stockholders.

• the enforceability of drag-along provisions added in a later equity financing round through amendment and restatement where no such provision was included in the original stockholders’ agreement, and where the amended and restated agreement is signed by less than all of the signatories to the original agreement (in such an instance, enforcement of the drag-along provision on non-signatories to the amended and restated agreement would entail relying on the amendment provisions of the original agreement).

• the enforceability of customary provisions in a venture capital voting agreement containing a drag-along provision and a covenant by the company to require future 1% or greater holders of common stock (including holders of stock options, who are typically “retail investor” employees) to execute a voting agreement.

• the enforceability of drag-along provisions against investors that are not represented by counsel in negotiations of a stockholders’ agreement.

• the portion of a company’s stockholder base that must remain “outside” the obligations of an advance waiver for a Delaware court to conclude that the waiver is not an impermissible blanket waiver of board liability for fiduciary accountability.

¹C.A. No. 2022-0406-JTL

²A drag-along provision is a common provision in venture capital and private equity stockholder agreements. It is a contracting tool used by parties to help facilitate the sale of a company. Typically, such a provision states that, if the corporation’s board of directors and some threshold group of stockholders approves a sale transaction, then the parties that have agreed to be “dragged along” must (a) vote in favor of the transaction (whether or not such parties are in fact in favor of the transaction), (b) take certain corporate actions that are necessary to facilitate the consummation of the transaction, (c) agree not to oppose the transaction or exercise appraisal rights, and (d) agree not to challenge or oppose the board of directors or significant stockholders over such a sale transaction. In venture capital transactions, there is usually a set of criteria for a sale transaction that must be satisfied for a drag-along provision to be enforceable, including the scope of the representations and warranties that the “dragged” stockholders must make, a maximum indemnification liability for such stockholders in the transaction, and a presumption that the transaction consideration will be allocated in accordance with the certificate of incorporation.

³When a company’s invested capital is significantly more than its present valuation, new investors often want to “reset” the company’s capital structure by converting the previous preferred stock into common stock, wiping away most of the preferences and rights of the prior preferred stock and reducing prior investors’ ownership percentage to accommodate the new capital being invested for which the investors receive new preferred stock. This type of transaction, which is common in the venture capital community, is often referred to as a “recapitalization.”

⁴Rutchik-affiliated entities had also participated in the recapitalization transaction.

⁵NEA at 12.

⁶NEA at 14.

⁷In an earlier decision in the case, the Court of Chancery denied a motion to dismiss counts VI, VII, and VIII based on arguments unrelated to the advance fiduciary duty waiver. As a result, the motion to dismiss at issue in the current opinion focuses solely on the advance waiver contained within the drag-along provision.

⁸NEA at 1.

⁹Sections 102(b)(7), 122(17), 102(a)(3), 144(a), 145, and 327 of the DGCL.

¹⁰Libeau v. Fox, 880 A. 2d 1049.1056 (Del.Ch.) aff’d in part, rev’d in part on other grounds, 892 A.2d 1068 (Del. 2006).

¹¹261 A.3d 1199 (Del. 2021).

¹²NEA at 109 (quoting Manti).

¹³NEA at 111 (quoting Manti).

¹⁴NEA at 7.

¹⁵C.A. 2017-0466-JRS-C (Del Ch. May 15, 2019).

¹⁶NEA at 117.

¹⁷NEA at 119.

¹⁸NEA at 120.

¹⁹The NEA court cited the one instance in which Delaware law allows well-informed and sophisticated parties represented by legal counsel to contract around tort-based claims for fraud. In ABRY Partners V, L.P. v. F & W Acquisition LLC, 891 A.2d 1032 (Del. Ch. 2006), the Delaware Supreme Court held that such parties can protect themselves from tort-based claims of fraud outside of the “four corners” of an acquisition agreement by including in that agreement appropriate language expressly disclaiming reliance on any representations and warranties made or deemed to be made outside of those representations and warranties included in the acquisition agreement itself.

²⁰NEA at 125-126 (quoting Data Mgmt. Internationale, Inc. v. Saraga, 2007 WL 2142848, at *5 (Del. Super. Ct. July 25, 2007)).

²¹NEA at 128.

²²See footnote 7.

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