New Enter. Assocs. 14 v. Rich
| Docket Number | C. A. 2022-0406-JTL |
| Decision Date | 02 May 2023 |
| Parties | NEW ENTERPRISE ASSOCIATES 14, L.P., NEA VENTURES 2014, L.P., NEA:SEED II, LLC, and CORE CAPITAL PARTNERS III, L.P., Plaintiffs, v. GEORGE S. RICH, SR., DAVID RUTCHIK, JOSH STELLA, FUGUE, INC., GRI VENTURES, LLC, JMI FUGUE, LLC, RICH FAMILY VENTURES, LLC, and RUTCHIK DESCENDANTS' TRUST, Defendants. |
| Court | Court of Chancery of Delaware |
Date Submitted: January 24, 2023
C Barr Flinn, Paul J. Loughman, Michael A. Carbonara, Jr. YOUNG CONAWAY STARGATT &TAYLOR, LLP, Wilmington Delaware; Michele D. Johnson, LATHAM &WATKINS LLP, Orange County, California; Eric Leon, Nathan Taylor, Meredith Cusick, LATHAM &WATKINS LLP, New York, New York Attorneys for Plaintiffs.
John P. DiTomo, Sebastian Van Oudenallen, MORRIS, NICHOLS, ARSHT & TUNNELL LLP, Wilmington Delaware; Patrick Montgomery, Paul Weeks, KING &SPALDING LLP, Washington, District of Columbia; Attorneys for Defendants.
LASTER, V.C.
This decision grapples with a conflict between two elemental forces of Delaware corporate law: private ordering and fiduciary accountability. Ordinarily, those forces operate harmoniously. Here, they pull in opposite directions.
Viewed from the standpoint of private ordering, this might seem like an easy case for contract enforcement: Sophisticated stockholders granted another investor a contract right to engage in a transaction that met specified criteria, and they promised not to sue the investor or its affiliates and associates if the investor exercised that right. The investor committed capital to the corporation in reliance on the stockholders' promise. Later, the investor exercised its contract right. Now, the stockholders are doing what they said they wouldn't do: sue over the transaction.
But like an Escher lithograph, the image changes with the viewer's perspective. The claims that the stockholders promised not to assert include claims for breach of fiduciary duty. The investor became the corporation's controlling stockholder, and individuals affiliated or associated with the investor took over the board of directors. The stockholders contend that by engaging in the contractually authorized transaction, the investor and the directors breached their duty of loyalty. In contrast to Delaware's alternative entity statutes, the Delaware General Corporation Law (the "DGCL") permits only limited fiduciary tailoring. Viewed from the standpoint of fiduciary accountability, this might seem like an easy case for contractual invalidity.
With the stage set, let's dig in. The plaintiffs are investment funds (the "Funds") managed by sophisticated venture capital firms. The Funds invested in a startup company called Fugue, Inc. (the "Company"). After backing the Company for half-a-dozen years, the Funds encouraged management to seek a liquidity event. The Company spent six months looking for a buyer, but no one expressed interest. After declaring the sale process a failure, the Company needed capital.
The Funds did not want to increase their financial commitment. Management represented that the only option was a recapitalization led by George Rich (the "Recapitalization"). He would only commit if (i) all existing preferred stock became common stock, (ii) Rich and his fellow investors received a new class of preferred stock (the "Preferred Stock"), and (iii) the Funds and other significant investors executed a voting agreement (the "Voting Agreement" or "VA"). The Funds accepted Rich's terms. They were given the chance to participate in the Recapitalization, but they declined.
The Voting Agreement contains a drag-along right. It provides that if the Company's board of directors (the "Board") and the holders of a majority of the Preferred Stock approve a transaction that meets a list of eight criteria, then the signatories must participate (the "Drag-Along Sale"). Critically for this case, the signatories covenanted not to sue Rich or his affiliates or associates over a Drag-Along Sale, including by asserting claims for breach of fiduciary duty (the "Covenant").
An opportunity to sell the Company soon materialized. The Company and the acquiror negotiated a Drag-Along Sale. That transaction has now closed.
In Counts VI, VII, and VIII of their complaint (the "Sale Counts"), the Funds have challenged the Drag-Along Sale and asserted claims for breach of fiduciary duty. The defendants argue that in light of the Covenant, the Sale Counts must be dismissed.
The Funds acknowledge that the Covenant covers their claims, and they concede that it was an inducement for Rich to invest. They assert that the Covenant is facially invalid.
The argument for facial invalidity starts from the settled proposition that fiduciary relationships are creatures of equity. The key move comes next and asserts that equity does not countenance limitations on fiduciary duties except to the extent authorized by statute. The DGCL does not authorize a provision like the Covenant. Therefore, the argument goes, it is contrary to Delaware public policy and cannot be enforced.
The argument against facial invalidity takes longer to unspool. It starts by recognizing that fiduciary duties can be tailored, even without statutory authorization. At the heart of every fiduciary relationship is an obligation of loyalty that cannot be eliminated without destroying its fiduciary character. Parties can, however, orient the obligation by specifying a purpose for the relationship, and they can authorize the fiduciary to take specific actions that otherwise would constitute a breach. Two paradigmatic fiduciary relationships-that of trustee to beneficiary and agent to principal-exemplify those opportunities for tailoring.
The argument next shows that Delaware corporate law adheres to those longstanding principles. The DGCL permits corporate planners to orient the fiduciary relationship between the directors and the corporation and its stockholders through a purpose clause. The directors must pursue the corporate purpose selflessly for the benefit of the corporation and its stockholders, but they are limited to pursuing the corporation's purpose. They cannot pick another path simply because they prefer it. The DGCL also allows more space for fiduciary tailoring and greater limits on fiduciary accountability than is widely understood. Delaware common law goes further, with existing doctrines achieving outcomes comparable to what the Covenant contemplates.
Having shown that corporate fiduciary duties are not immutable, the argument against facial invalidity turns to the contractarian nature of Delaware corporate law. A close analysis of the DGCL shows that through a private agreement, stockholders can agree to more constraints on their ability to exercise stockholder-level rights than corporate planners can impose through the charter or bylaws. The Covenant appears in a stockholder-level agreement and concerns a stockholder-level right.
This in-depth analysis indicates that the Covenant is not out of bounds as a form of fiduciary tailoring. The analysis next turns to other indications of where Delaware might draw a public policy line.
An intuitively appealing argument asserts that a claim for breach of the duty of loyalty is too big to waive. One way to evaluate that argument is to consider what else is waivable. Delaware law permits individuals to waive significant liberty and property interests that are arguably weightier than a right appurtenant to a share. The comparison suggests that the Covenant is not facially invalid.
A rhetorically powerful argument asserts that permitting stockholders to covenant not to sue for breach of the duty of loyalty would conflict with Delaware's corporate brand, which promises standardized terms, including an immutable duty of loyalty. The promise of standardized terms should not be overstated, because Delaware's support for private ordering means that an investor cannot assume that one Delaware corporation is like another. The promise of an immutable duty of loyalty is also overstated, because the duty can be oriented and tailored. Regardless, a stockholder-level agreement about the exercise of stockholder-level rights does not undermine the corporate brand, because the underlying rights remain intact. Each stockholder receives the underlying rights and can exercise them. The stockholder-level agreement only binds its signatories and only affects how they exercise their rights.
Another rhetorically powerful argument asserts that permitting a stockholder to covenant not to sue for breach of the duty of loyalty will collapse the distinction between a corporation and an LLC. That is not so, as the fundamental differences between corporations and LLCs operate at the basal level of their statutes and constitutive documents. There is a superficial similarity between the ability of investors in corporations and LLCs to contract about their investor-level rights, but that resemblance does not turn corporations into LLCs.
A final argument for invalidity relies on the Delaware Supreme Court's decision in Manti Holdings, LLC v. Authentix Acquisition Co.[1] There, sophisticated stockholders agreed to a drag-along provision in which they covenanted not to pursue their appraisal rights. The stockholders sought to escape their promise by arguing that the provision conflicted with the DGCL and was contrary to Delaware public policy.
A majority of the Delaware Supreme Court upheld the appraisal waiver, stressing the contractual freedom that Delaware corporate law provides and citing a list of factors that apply equally to this case. But the justices also emphasized that they were not upholding all waivers of appraisal rights and th...
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