Shareholders versus directors – who wins?

November 2024 | SPOTLIGHT | BOARDROOM INTELLIGENCE

Financier Worldwide Magazine

November 2024 Issue

The balance of power between shareholders and directors in a company is an area that has seen an abundance of legal and jurisprudential commentary over the years, yet it remains an area that generates litigation.

On 23 February 2024, the Delaware Court of Chancery issued its decision in West Palm Beach Firefighters’ Pension Fund v. Moelis & Company, whereby the enforceability of certain shareholder pre-approval rights pursuant to a shareholder agreement had been challenged under section 141(a) of the Delaware General Corporation Law (DGCL).

Illustrating that courts can still spring surprises in areas that market participants may have long considered relatively settled, the decision was promptly followed by the enactment of certain amendments to the DGCL by the Delaware legislature to re-establish legal certainty regarding the enforceability of shareholder arrangements under Delaware law.

While this case is applicable to Delaware corporate law, it provides an opportunity to look again at this area from the perspective of the board, including board members not nominated by any particular investor or shareholder group, and whether the legal principles that inform that perspective differ materially as between the US, the UK and Canada.

Shareholders’ ‘reserve power’

As highlighted in the Moelis decision, it is common for shareholders in US companies to have certain consent rights over important governance decisions, generally through shareholder agreements that provide these shareholders some say in decisions that could significantly affect the company’s business.

A prime example of this is the shareholder protection provisions in the National Venture Capital Association form documents used in the venture capital market in the US, as well as their equivalent British Private Equity & Venture Capital Association and Canadian Venture Capital & Private Equity Association form documents.

More fundamentally, the ‘model’ constitutional documents for UK private companies have long reflected a power of shareholders to direct, by special resolution, directors to take or refrain from taking any specified action. Consistent with this, in Canada, shareholders have historically relied on shareholder agreements to restrict in whole or in part the power of a board of directors.

The ability to implement such restrictions is enshrined directly in corporate legislation for most Canadian provinces which specifically authorises shareholders to restrict, in whole or in part, the powers of the directors to manage, or supervise the management of, the business and affairs of the corporation by entering into a unanimous shareholders agreement.

Through a unanimous shareholders agreement, shareholders can supplement and amend the provisions established by a Canadian company’s organisational documents and can also opt-out of certain protections and requirements provided in the company’s governing statute.

Shadow director issues aside, what does this mean in the real world? For instance, can shareholders pass a resolution requiring the board to undertake an act that would be illegal for the company? Clearly not.

The question becomes more nuanced, however, once board members seek to rely on ‘compliance with directors duties’ as a basis for rejecting a shareholders’ direction. Board members in highly regulated sectors such as insurance, banking or asset management may be additionally concerned with the impact a directed action (or direction to refrain from acting) may have on the company’s relationships with its primary regulators.

Director duties

In this context, in the UK, the duty under section 171 of the Companies Act 2006 (CA 2006) requires directors to “act in accordance with the company’s constitution”. As shareholder resolutions form part of the “constitution”, section 171 duty reinforces the need for the board to comply.

But what about the other duties, in particular the section 172 duty (to promote the success of the company) and section 174 duty (to exercise reasonable care, skill and diligence)? What happens if a director forms a view that the particular action would result in non-compliance with such duties?

In this UK context, there is a potential conflict between the respective duties. Does the section 171 duty have primacy and effectively shield the relevant board members from a breach of the other duties in that situation? If it does, could that ‘shield’ operate more extensively?

The prevailing view is that section 171 should have primacy in such a situation. That being the case, it seems logical that the directors should not be in breach of their other duties as they are not exercising their discretion in taking (or refraining from taking) such action. Clearly, where a financial distress situation exists, that may bring other factors and potential liabilities into play.

In Canada, some of these questions have been addressed through legislation. Under section 122 of the Canada Business Corporations Act (CBCA), each director is statutorily obligated to comply with its regulations, the articles and bylaws of the company and any unanimous shareholders agreement. However, the statute further notes that no contractual provision, articles, bylaws or a resolution of the company relieves a director or officer from the duty to act in accordance with this statute or its regulations or relieves them from liability for a breach thereof.

This premise is subject to the fact that if a unanimous shareholder agreement restricts the powers of the directors to manage, or supervise the management of, the business and affairs of the company, parties to the unanimous shareholder agreement who are given that power have all the rights, powers, duties and liabilities of a director of the company, whether they arise under the statute or otherwise, including any defences available to the directors, and the directors are then relieved of their rights, powers, duties and liabilities.

In addition, section 123 of the CBCA also provides directors with the ability and authority to dissent to actions being authorised at a meeting of the board or by written resolution, thereby allowing a director to illustrate their disagreement and reduce the risk of personal liability.

In respect of Delaware, the board may approve the company entering into a shareholder agreement with terms addressing action or inaction by the board so long as such an agreement does not violate the company’s certificate of incorporation and would not violate Delaware law if included in the certificate of incorporation.

To proactively address any concern a shareholder consent right could run afoul of the board’s fiduciary duties, parties may contemplate including a provision that such rights are not applicable to the extent they would be inconsistent with the fiduciary duties of the board.

Breach of contract

Falling short of illegality, board members will clearly still be concerned about any direction that could require the company to do something that might amount to a breach of any contract or agreement to which the company is a party.

In the UK, although the company would not be protected from any liability arising from such a breach, directors themselves might be able to avail themselves of section 1157 CA 2006 which allows the court to grant relief to any officer of a company where the court determines they have acted honestly and reasonably and ought fairly to be excused (in this case because they were only acting in compliance with a resolution of shareholders).

For a Delaware company, the board is protected by certain presumptions, which together form the ‘business judgment rule’, that provides that so long as the duty of loyalty is respected, a court will not second guess if a decision was made with due care and in good faith.

Balance of interests

Staying with Delaware, the Chancery Court continues its efforts to maintain the balance between protecting shareholder interests and providing flexibility for directors to manage companies effectively.

In Moelis, the challenged provisions were found to be facially invalid by the court because they substantially removed the directors’ duty to use their own best judgment on virtually every management matter.

Section 141(a) of the DGCL reads: “[T]he business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation.” This language is often described as the source of Delaware’s board-centric model of corporate governance.

However, it has become common practice for controlling shareholders to retain corporate governance rights through shareholder agreements, thereby limiting board authority. The Delaware legislature quickly determined that statutory guidance was necessary in light of the Moelis decision, particularly given the common use of shareholder agreements, so approved a new subsection 122(18) of the DGCL, which became effective on 1 August 2024.

This created a default rule that explicitly authorises a company to enter into certain contractual arrangements with its shareholders and beneficial owners, regardless of whether such actions are listed in the company’s governance documents.

These amendments reflect a rare example whereby the Delaware Senate mimicked Canadian corporate law such as section 146(1) of the CBCA, which explicitly permits shareholders to supersede the management of a corporation by authorising shareholders to restrict the powers of the directors to “manage, or supervise the management of, the business and affairs of a corporation”.

Conversely, the DGCL was, prior to 1 August, close to silent. It remains that, while DGCL followed Canadian corporate statute law, it did not contain a provision relieving directors of their duties and liabilities to the extent that such duties and responsibilities are adopted by shareholders pursuant to a shareholders’ agreement, as provided in section 102(1) of the CBCA.

Conclusion

Overall, the UK and Canadian positions emphasise the ability of shareholders, particularly when acting in unison in the case of Canada, to require the board of a corporation to take (or refrain from taking) a specific action, whereas the DGCL emphasises board primacy.

While preeminent US corporate jurisdiction empowers the board in respect of corporate governance, it remains subject to this intrinsic complex paradigm: ultimately seeking to balance the interest of all to create long term, sustainable value for the corporation.

Alan Bainbridge, Kristopher Miks and Ryan L. Waggoner are partners at Norton Rose Fulbright LLP. Mr Bainbridge can be contacted on +44 (0)20 7444 3279 or by email: alan.bainbridge@nortonrosefulbright.com. Mr Miks can be contacted on +1 (604) 641 4806 or by email: kristopher.miks@nortonrosefulbright.com. Mr Waggoner can be contacted on +1 (212) 318 3050 or by email: ryan.waggoner@nortonrosefulbright.com.

Alan Bainbridge, Kristopher Miks and Ryan L. Waggoner

Norton Rose Fulbright LLP