New Enterprise Associates 14, L.P. v. Rich
May 2, 2023 (Date Decided) (Not yet reported) (2023)
Rule of Law:
In Delaware, a covenant not to sue for breach of fiduciary duty, contained within a stockholder-level agreement among sophisticated parties and narrowly tailored to a specific transaction, is not facially invalid or unreasonable as applied, but it cannot insulate defendants from tort liability for intentional wrongdoing or bad faith.
Facts:
- Plaintiffs, investment funds managed by sophisticated venture capital firms (the “Funds”), invested almost $39 million in Fugue, Inc. (the “Company”) over several years, receiving preferred stock and the right to appoint a board member.
- By 2020-2021, the Funds urged the Company's CEO, Josh Stella, to seek a liquidity event, but a six-month sale process failed, leading to a need for capital.
- George Rich proposed a recapitalization (the “Recapitalization”) where all existing preferred stock converted to common, Rich and his investors received a new class of preferred stock, and significant investors, including the Funds, executed a Voting Agreement.
- The Funds declined to participate in the Recapitalization but, as "Signatories," executed the Voting Agreement, which included a "Drag-Along Right" and a "Covenant" not to sue Rich or his affiliates/associates over a Drag-Along Sale, explicitly including claims for breach of fiduciary duty.
- After the Recapitalization, Rich and David Rutchik, representatives of the new investors, joined the Company's five-member board, alongside Stella.
- In late June 2021, a potential acquirer contacted Stella, contrasting with the previous failed sale process.
- After the two independent directors resigned in July 2021, the remaining directors (Stella, Rich, and Rutchik) authorized two "Interested Transactions": a second issuance of Preferred Stock to Rich and Rutchik, and large stock option grants to themselves.
- By September 2021, merger discussions advanced, leading to an agreement in principle in December 2021 to sell the Company for $120 million in cash, which ultimately closed on February 17, 2022.
Procedural Posture:
- The Funds filed a lawsuit in the Delaware Court of Chancery asserting eight counts against the defendants, including three "Sale Counts" for breach of fiduciary duty relating to the Drag-Along Sale and other interested transactions.
- The defendants moved to dismiss the complaint, arguing, among other things, that the Covenant foreclosed the Sale Counts.
- In a prior "Pleading Decision," the Delaware Court of Chancery held that the Sale Counts stated claims upon which relief could be granted based on the factual allegations, but explicitly reserved judgment on the defendants' argument that the Covenant barred these claims.
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Issue:
Does a covenant not to sue for breach of fiduciary duty, contained within a stockholder-level agreement among sophisticated parties and narrowly tailored to a specific transaction, violate Delaware public policy, either facially or as applied, by impermissibly limiting fiduciary accountability in a Delaware corporation?
Opinions:
Majority - Laster, V.C.
No, a covenant not to sue for breach of fiduciary duty in a stockholder-level agreement is not facially invalid or unreasonable as applied if narrowly tailored to a specific transaction, but it cannot prevent claims for intentional wrongdoing or bad faith. The Court found that Delaware corporate law, despite its emphasis on fiduciary accountability, permits significant fiduciary tailoring through various statutory provisions (e.g., DGCL Sections 102(b)(7), 122(17), 141(a), 145) and common law doctrines (e.g., contractual preemption, advance ratification, laches). These mechanisms demonstrate that the law allows for the authorization of specific transactions that might otherwise constitute a breach, or limitations on the assertion of claims. The court emphasized Delaware's strong public policy favoring private ordering, especially in stockholder-level agreements where sophisticated parties negotiate over their private property rights (e.g., rights to sell, vote, and sue). Such agreements, involving explicit consent, offer greater flexibility for contractual constraints than provisions embedded in the corporate charter or bylaws. Applying a two-step analysis derived from Manti Holdings, LLC v. Authentix Acquisition Co. and In re Altor Bioscience Corp., the Court determined the Covenant was (1) sufficiently specific, as it applied only to a "Drag-Along Sale" meeting eight precise criteria, thus avoiding the pitfall of a broad, unspecified waiver. The Covenant did not give defendants a blank check but limited the Funds' ability to sue over a specified transaction with specific characteristics. It also found the Covenant (2) reasonable as applied to the facts: it was an express, bargained-for provision in a written contract; its terms were clear; the Funds were sophisticated, repeat players, represented by counsel, who understood its implications and had the bargaining power to reject it; and it was supported by consideration (inducing Rich's investment in the Recapitalization). Invalidating it would shift value and exposure contrary to the bargained-for exchange. However, the Court also held that a covenant not to sue, like other contractual provisions, cannot relieve defendants of tort liability for intentional or reckless harm. While DGCL Section 102(b)(7) allows exculpation for recklessness in the corporate context, the limited exception carved out by Abry Partners for anti-reliance clauses in fraud claims has not been extended to other intentional torts. Therefore, to the extent the Sale Counts supported liability for intentional breaches of fiduciary duty or bad faith, the Covenant could not bar them, and the defendants' motion to dismiss on this ground was denied.
Analysis:
This decision significantly clarifies the enforceability of covenants not to sue for fiduciary duty breaches in Delaware corporations, affirming the balance between private ordering and fiduciary accountability. It suggests that such covenants are viable tools for sophisticated investors to manage risk, especially in venture capital contexts, provided they are narrowly tailored and do not seek to exculpate intentional misconduct or bad faith. The ruling reinforces Delaware's contractarian bent for stockholder agreements but maintains a crucial public policy floor for intentional torts, potentially influencing how future investment agreements are structured and litigated. This also provides an important distinction between the scope of waivers permissible in stockholder agreements versus corporate charters/bylaws.
