Stock is personal property, giving its owner three fundamental rights―the rights to sell, to vote and to sue. Limitations on the rights to sell and to vote are myriad in Delaware law. In New Enterprise Associates 14, L.P. v. Rich, C.A. 2022-0406-JTL, 2023 WL 3195927 (Del. Ch. May 2, 2023), Vice Chancellor J. Travis Laster confronted the question of whether, how and to what extent stockholders can contract away their right to sue, the mechanism by which all other property rights are secured.

Notably, Vice Chancellor Laster’s opinion determined the enforceability of a covenant not to sue in a stockholder agreement based on a model agreement from the National Venture Capital Association (NVCA). NVCA model agreements are widely used by startups and other venture-capital-financed businesses. As a result, the court’s decision has repercussions for a wide range of stakeholders in the venture capital industry.

Examining the span of Delaware fiduciary law, the vice chancellor determined that stockholder anti-suit covenants, even as to the fiduciary duty of loyalty, are valid if they can satisfy a stringent two-part test and are enforceable within limits set by Delaware public policy.

The covenant must be specific at step one and reasonable at step two; if so, it will be enforceable consistent with Delaware’s public policy prohibiting advance exculpation of intentional harms.

The court’s framework provides critical forward guidance to all stakeholders on how to draft and negotiate enforceable anti-suit covenants and, equally as important, how fiduciaries protected by the covenants should act to ensure the covenants remain enforceable. Finally, the court’s decision sets forth the standards of pleading and proof that a stockholder must satisfy to proceed with a lawsuit after covenanting not to sue.

Step One: What Kind of Anti-Suit Covenants Are Permitted?

A major part of Vice Chancellor Laster’s analysis consists of a scholarly examination of the circumstances and ways in which beneficiaries of fiduciary relationships can alter the default duties and obligations of their fiduciaries in advance via the documents forming the fiduciary relationship―trust instruments, corporate charters and the like. Terming these alterations “fiduciary tailoring,” the court reckoned that both common law and statutory mechanisms for those alterations are numerous. By way of example, a settlor’s instructions on trust administration, or a corporate charter’s limited corporate purpose clause (Delaware General Corporation Law (DGCL) § 102(a)(3)), take precedence over a fiduciary’s obligation to engage in value maximization and so modify the fiduciary duty. Further, under DGCL § 102(b)(7) corporations are permitted in their charters to exculpate directors and certain specified officers from monetary liability for good faith breaches of the duty of care, but that exculpation is limited and cannot, for example, extend to breach of the duty of loyalty.

The court construes modifications of the fiduciary duty of loyalty―as opposed to the duty of care―as permissible but lying within, although at the outer edge, of fiduciary tailoring.

Critical to NEA’s ultimate question was one of fiduciary tailoring contained not in the corporate charter, but in a stockholders’ agreement. Unlike Section 102(b)(7)'s express prohibition of exculpation of the duty of loyalty in a corporation’s charter, in a stockholders’ agreement—especially one negotiated by sophisticated contractual counterparties—the Delaware courts tend to respect the well-established principles of parties' freedom of contract.

Delaware affords a legendary respect to parties' freedom of contract. Thus, an anti-suit covenant in a stockholder’s contract is merely the stockholder’s decision to dispose of their ability to exercise personal property rights, and so has “greater space” for private ordering than a corporate charter possesses to alter the existence of the property rights. The court therefore reasoned that stockholders’ personal liberty to encumber property should not be subject to the same limitations as corporate documents. But, at the same time, the court reasoned that the existing general framework for fiduciary tailoring provides the essential backdrop for how those private contracts should be understood, thus arriving at the first step of the test:

First, the provision must be narrowly tailored to address a specific transaction that otherwise would constitute a breach of fiduciary duty. The level of specificity must compare favorably with what would pass muster for advance authorization in a trust or agency agreement, advance renunciation of a corporate opportunity under Section 122(17), or advance ratification of an interested transaction like self-interested director compensation. If the provision is not sufficiently specific, then it is facially invalid.

Applied to NEA, the NVCA-based clause had eight separate requirements for transactions to trigger the drag along and thus also trigger the anti-suit covenant. This, the court concluded, was adequately specific to pass muster. Rather than an impermissible blanket disavowal of the fiduciary duty of loyalty, the court blessed the NVCA language as an appropriately narrow waiver of the right to sue over a highly specific type of merger transaction.

Step Two: What Constitutes Reasonableness?

Next, the vice chancellor addressed a series of policy concerns and counterarguments that formed the basis of dispute between the majority and dissenter in Manti Holdings, LLC v. Authentix Acquisition Co., 261 A.3d 1199 (Del. 2021). The Manti case concerned the same clause of the NVCA model agreement―the earlier part of the same sentence, containing a covenant to “refrain” from exercising stockholder appraisal rights in a drag-along-triggered merger transaction. The lone Manti dissenter argued that appraisal rights went to the fundamental structure of the corporate form, and so eliminating appraisal rights threatened to collapse the distinction of corporations from alternative entities (such as LLCs and partnerships) and skewed the checks and balances among corporate stakeholders by creating what amounted to a shadow charter via stockholders' agreement. The Manti majority disagreed, putting heavy emphasis on the particular circumstances of that transaction, with its highly sophisticated, adequately counseled, repeat-player parties involved in it.

In NEA, Vice Chancellor Laster construed the Manti majority’s focus on those particular circumstances as imposing on the Court of Chancery an independent responsibility to hold provisions like the anti-suit covenant to “close scrutiny for reasonableness.” Further, he relied on the “non-exclusive factors suggested in Manti” as guiding that inquiry. He also noted an additional reasonableness consideration―whether the covenant left any similarly situated stockholders unbound. Because uncovenanted stockholders’ ability to sue necessarily protects the covenanted stockholders as well, the potential abuse of fiduciary impunity is ameliorated.

In the case at bar, because (i) the covenanting stockholders were sophisticated venture capital funds, (ii) the provision was clear and the covenanting funds actually understood it at the time of agreement, (iii) covenanting funds were in control of the company when they chose to undertake the covenant, and (iv) the covenanting funds understood it to be an important component of the consideration to the new investors in such recapitalization transactions, the court found the covenant reasonable.

The court went out of its way to note that the reasonableness analysis is specific to each covenanter. The NEA plaintiffs are all themselves sophisticated venture capital funds, while other covenanting parties who did not join the suit as plaintiffs appeared to be “line employees, and some look like friends and family.” The court suggested that the reasonableness analysis as it relates to those parties may be different. Had they sued, the court speculated that “[w]hether the Covenant could bind them is a different question that could require discovery to answer.” Comparing anti-suit covenants with employee noncompetes, for which the Court of Chancery has denied enforcement in a number of recent cases, the vice chancellor explained that “[t]here may well be other use cases for a provision like the Covenant, but they are likely to be few and limited to agreements between uber-sophisticated parties” such as the covenanting funds in NEA.

What Limits Are Placed by Public Policy?

Viewing the two-step test as satisfying the strictures of fiduciary law, the court nevertheless took the view that Delaware public policy abhors the use of anti-suit covenants to shield intentional wrongdoing. Citing then-Vice Chancellor Strine’s seminal Abry Partners V, L.P. v. F&W Acquisition LLC decision and the DGCL’s authorization of exculpation for conduct up to recklessness, Vice Chancellor Laster reasoned that recklessness is likewise the limit for anti-suit covenant protection. So long as the defendants “believed in good faith that the transactions were not contrary to the best interests of the Company,” or at worst had a “reckless disregard for the best interests of the Company,” the covenant barred suit. To advance to discovery (or eventually prevail) the court held a covenanted plaintiff must plead and prove that the controller had intentionally acted contrary to those interests. Because it held the NEA plaintiffs met those pleading criteria, the court declined to dismiss.

What Should Practitioners and Investors Take Away From This Decision?

Anti-suit covenants are a common clause in private equity contracts―as the opinion notes, the covenant in this suit tracks model language from the NVCA, from the very same sentence at issue in 2021’s Manti decision. In this opinion, Vice Chancellor Laster has provided transactional attorneys and private equity investors with a road map for how to design a covenant that will pass muster:

  • Anti-suit covenants must narrowly describe the specific type of transaction that the parties want to exclude from litigation. A drag along with specific requirements for a qualifying transaction using NVCA model language passes muster.
  • Covenants will only be given binding effect when they are reasonable in light of the sophistication and bargaining leverage of the parties. The court has given every indication that properly drafted NVCA-style covenants will be given effect as applied to sophisticated repeat market players, but are of dubious enforceability against knowledge-worker employees receiving equity as part of their compensation packages.
  • Fiduciaries should not treat the existence of a covenant as a license to ignore the underlying fiduciary rights. The protection of a covenant requires a good faith belief that the actions taken are in the best interest of the company and its stockholders. The covenant will not protect a fiduciary against an allegation that they intentionally put the interests of another―such as their own investor group―first.

In sum, drafters should take care to ensure that covenants are narrow and are not imposed by use of unequal bargaining leverage. Further, parties seeking exit transactions should not seek to overreach on the supposition that a covenant will block allegations of deliberate misconduct.