Moelis Ruling Sharpens Focus on Private Equity Veto Agreements

A first-of-its-kind court decision involving investment bank Moelis & Co. threatens the growing corporate practice of giving a company’s financial backers significant authority, by contract, over core managerial decisions.

The ruling by a Delaware judge—invalidating most of an agreement between the company and billionaire founder Kenneth Moelis—was the first to grapple with a wave of shareholder pacts giving extensive veto rights to early investors. Other businesses that have faced similar legal challenges include Alignment Healthcare Inc., EngageSmart Inc., and Petco Health & Wellness Co.

Structural changes in the US economy have put the contracts in the legal crosshairs for the first time even though “companies have been adopting more or less similar agreements for many years,” according to Stephen Ram, a partner at Stradling Yocca Carlson & Rauth LLP. He pointed to the growth of private markets that let venture-backed businesses delay their initial public offerings by years.

“These firms have gotten much more aggressive in how much say they have with their investments, particularly if they’re coming in with capital at that magic moment where they have more negotiating power,” Ram said. “The issue has become more ripe.”

Vice Chancellor J. Travis Laster on Feb. 23 rejected the constellation of approval rights held by Moelis, the investment bank’s chairman and CEO, who had the final say over its leadership, litigation strategy, budget, business plans, and charter, as well as any dividend payment or stock issuance. That’s in addition to the roughly 40% voting power that came with his 6.5% stake.

Read More: Delaware’s Judge Laster Is Making His Mark on Corporate America

Constrained by those veto provisions, “the board is not really a board,” the judge said, although he upheld other sections of the agreement.

For decades, “nobody really has scrutinized shareholder agreements before on this basis, looking at the extent to which they may be in tension with the idea that the board of directors fundamentally manages the corporation,” said Jill Fisch, a University of Pennsylvania law professor. “If you change that, is that really consistent with Delaware law? And how far can you change it?”

New Backlash

The Moelis case reflects “a really tectonic shift in the architecture of corporate law,” said Gabriel Rauterberg, a University of Michigan law professor. Delaware’s courts have shown an increased willingness in recent years to accept creative, bespoke arrangements altering the default corporate form, he said.

The decision hinted at the limits of that openness by “drawing some lines at the most aggressive shareholder agreement I’ve seen,” but it also raised significant questions about how a more modest collection of veto provisions might fare, according to Rauterberg. The Moelis pact was “an unusually extreme concatenation of shareholder rights, entered under less-than-ideal circumstances, and targeted at one of the pillars of Delaware corporate law,” he said.

The litigation echoes other disputes, most of them involving more recently listed companies: IT services company N-able Inc., autobody chain owner Driven Brands Holding Inc., revenue management business R1 RCM Inc., grill manufacturer Traeger Inc., payments platform EverCommerce Inc., and HireRight Holdings Corp., which performs employment-related background checks.

The investors holding veto rights in those cases include Silver Lake Group LLC, Thoma Bravo LLC, General Atlantic LP, Roark Capital Group Inc., and several Canadian pension funds.

Laster’s 133-page opinion for Delaware’s Chancery Court relied on Section 141 of the state’s General Corporation Law, which enshrines the idea that companies should be managed by their boards. The judge acknowledged that shareholder agreements containing extensive veto rights aren’t necessarily new. But “the seemingly irresistible force of market practice” must yield to “the traditionally immovable object of statutory law,” he said.

The decision was “actually less about veto rights and more about the scope of shareholder agreements,” according to Fisch. “What he’s saying is that shareholder agreements are legitimate when they deal with the exercise of shareholder power,” she said. “But they can’t be used to trump the board’s statutory authority to run the corporation or to take away powers that are typically within its purview.”

‘Systematic Theory’ Signals

The judge suggested several times that the problem with the Moelis veto clauses was the way the company adopted them, not the fact that it did. Ken Moelis “could have accomplished the vast majority of what he wanted through the company’s certificate of incorporation,” even if that might seem like a “bizarre” technicality, Laster said.

The distinction actually speaks to “some pretty fundamental considerations,” particularly whether ordinary investors get a chance to weigh in on proposed changes to a default rule of corporate law, according to Rautenberg. Amending the charter to add veto rights for a particular investor requires “a full shareholder vote, which provides an additional layer of check against abuses,” he said.

It’s also harder for a company to hide the ball that way. “Charter provisions have transparency,” Fisch said. “Shareholder agreements may not be seen or understood by minority shareholders, they can have custom terms that are hard to predict or price, and that flexibility also reduces the stability of a corporation’s governance system.”

Moelis can be seen as a sort of bookend to another novel recent decision by Laster, according to Rauterberg, who cited the judge’s 130-page opinion last year in a case involving cloud computing startup Fugue Inc. Laster ruled at the time that sophisticated investors can sometimes give up their fiduciary rights—even those that can’t traditionally be waived—if they do so through crystal-clear language in a stockholder agreement that doesn’t bind other parties.

Read More: New Enterprise Overcomes Novel Ruling to Get Narrow Court Win

Taken together, Laster’s rulings have only just begun the project of carving out “a fully thought-through, systematic theory” for how to change corporate default rules, Rauterberg said. “I think corporate law deserves one, and that the Delaware courts in the next decade will be forced to carefully think through the core policy considerations relevant to determining how parties should be able to change rules. It’s perhaps the single most profound issue behind all of these cases.”

Fiduciary Risks

That’s not the only important question Laster left unanswered. Because the Moelis agreement was so far over the line, the judge opted to analyze the veto rights collectively, saying they “look like something a law professor dreamed up” to illustrate a prototypical violation.

That means he stopped short of providing specific guidance like, “Provision A is always going to violate the law, provision B can be fine at times, provision C is always okay,” Ram said. “Moelis is a little bit of an outlier, and because of that it’s hard to know what all the takeaways are.”

Nor did Laster address another closely watched issue: whether, or when, a shareholder agreement can bestow so much influence that it comes with burdensome fiduciary duties. A ruling to that effect could complicate the portfolios of investment firms with broad holdings across a single sector, according to Ram, given that fiduciary duties encompass the “corporate opportunity doctrine,” which requires a company’s insiders to give it a first shot at any relevant deals.

“There’s a lot left to be litigated, and I expect this wave to continue until there’s something more authoritative,” he said. “But I do think it behooves private equity firms and venture capitalists to really consider it: What’s the risk you want to live with in exchange for control?”