In New Enterprise Associates 14 v. Rich, C.A. 2022-0406-JTL, 2023 WL 3195927 (Del. Ch. May 2, 2023) (NEA), the Delaware Court of Chancery discussed the enforceability of covenants not to sue for breach of fiduciary duty contained in stockholders’ agreements. The court reasoned that Delaware law permits such covenants, subject to two ifs and one but—and declined to dismiss, reasoning that the covenant at issue was valid but that plaintiffs had adequately pleaded intentional fiduciary misconduct.

The court’s magisterial opinion pays significant attention to the foundations of corporate law, including an extended footnote (almost as long as the court’s entire recitation of facts) explaining Vice Chancellor J. Travis Laster’s ontological conception of what a corporation is. While this blockbuster opinion has received a great deal of attention for the watershed test for anti-suit covenants it creates, less attention has been paid to the foundational conception of the corporate form which it articulates. The importance of that aspect of the decision is likewise profound, as it is informative of how one of Delaware’s most influential trial jurists will approach other key legal questions in future cases.

The First If: Facial Validity

Following a “tour through traditional fiduciary law,” the court concluded that beneficiaries of fiduciary relations possess the power to make limited exceptions to default fiduciary duties, a process the court calls “fiduciary tailoring.” For example, corporate charters can specifically renounce identified corporate opportunities or specific classes of opportunities (8 Del. C. Section 122(17)) overriding the ordinary fiduciary duty of directors to present such opportunities to the corporation first. The court held that a covenant not to sue for breach of fiduciary duty is facially valid if it identifies the type of transaction over which the covenant is to operate with an analogous level of clarity.

The covenant at issue in NEA excluded from suit only certain specified drag-along merger transactions, using language drawn from the National Venture Capital Association’s (NVCA) Model Voting Agreement. Transactional attorneys will be relieved to learn that the Court held the NVCA drag-along clause is adequately specific to be facial valid under Delaware law.

The Second If: Reasonableness

Beyond facial validity, however, the court recognized that covenants not to sue differ from fiduciary tailoring in the constitutive documents of a fiduciary relationship (e.g., corporate charters or trust agreements) in a critical way: they relate to a private party’s exercise of a property right. Choices in action over a right are analytically distinct from the right itself, and so the court reasoned that covenants must be accorded “greater space for private ordering, not less, when the provision appears in a stockholders agreement.”

Fundamentally, anti-suit covenants contained in private contract represent an unstoppable force (Delaware’s legendary respect for contract rights) colliding with an immovable object (the duty of a court of equity to guard the vulnerable). The court resolved the tension by imposing a second-step analysis: facially valid covenants like the one in NEA are subject to the court’s independent evaluation for reasonableness. The court pointed to the majority opinion in Manti Holdings v. Authentix Acquisition, 261 A.3d 1199 (Del. 2021), discussing covenants not to seek appraisal, as containing a set of “nonexclusive” factors for this analysis.

Putting heavy emphasis on the NEA plaintiffs’ sophistication and negotiating leverage at the time the covenant was created, the court held that the covenant was valid against the plaintiffs at bar, while repeatedly stressing that even that same covenant might not bind other plaintiffs who lack those resources. As the court explained, “There 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” like the venture capital funds on both sides of the “v.” in NEA. Critical to the court’s analysis was that the defendants obtained the covenant contemporaneously with their investment—meaning that they obtained it from the company’s then-controllers as part of the consideration for the transaction, rather than using their control over the instruments of corporate power to impose it on others.

The But: Public Policy

After defining those two ifs as the two-step test for the validity of anti-suit covenants in Delaware, the Court announced a limitation on their enforceability based on Abry Partners V, L.P. v. F&W Acquisition 891 A.2d 1032 (Del. Ch. 2006). Delaware public policy abhors the use of covenants to exculpate intentional (as opposed to reckless or negligent) harms. As a result, irrespective of whether a plaintiff was subject to a valid covenant not to sue, the court reasoned that the covenant cannot be enforced, and the suit may proceed, if the plaintiff pleads and proves that the fiduciary intentionally acted contrary to the beneficiaries’ interests.

A careful reader will note that this but functions in a manner very similar to “unclean hands.” As the Court of Chancery has previously explained in American Healthcare Administrative Services v. Aizen, 285 A.3d 461 (Del. Ch. 2022) and elsewhere, Delaware recognizes unclean hands not as an equitable defense, but rather as a public policy against lending the court’s aid in the commission of an act repugnant to public policy. NEA’s public policy exception operates, in effect, as an interposition of unclean hands against the defendant’s effort to invoke specific performance of a contractual obligation.

Guidelines for Practitioners

The court’s decision sets forth several clear guidelines for practitioners and all actors in the private equity space.

To transactional attorneys, the opinion gives a qualified endorsement of NVCA language, while stressing that parties should anticipate that only sophisticated, represented parties will be bound by it.

To venture capital funds, the covenants should be seen as a means of reducing litigation risk ‒ not a means of eliminating it, and not as a license to misbehave.

Plaintiff-side litigators should anticipate needing to plead and prove that self-dealing controllers intentionally put their own (or their funds’) needs ahead of the company’s or minority’s to survive a motion to dismiss. Additionally, plaintiffs may want to put thought into assembling a coalition of stockholders to prosecute fiduciary cases—the joinder of employees whose holdings came from sweat equity may aid in avoiding application of a covenant.

The Metaphysics of Business Entities

In addition to its palpable practical importance, NEA contains extensive discussion of an issue of great importance to Delaware practitioners: what is a corporation?

NEA is not the first opinion from Laster to spend significant time ruminating on the nature of the corporate form. In an extensive footnote (at over 1,200 words, footnote 159 is nearly as long as the opinion’s recitation of facts, and stretches across three pages), the vice chancellor expresses his metaphysical understanding of the corporate form. Because corporations have powers that private parties cannot create by contract, like limited liability and the capacity to own property or to sue and be sued, they are necessarily creations of state power, rather than creations of their incorporators alone. Vice Chancellor Laster in NEA asserts his view that entities – whether corporations or LLCs/LPs—are never entirely “creatures of contract.” But, he writes:

[This conception] leaves open the question of what the state has created when it charters an entity. The answer is an autonomous form of intangible property, with biological humans serving as the ghost in the machine that enables the form of property to engage with the world. Someday, artificial intelligence may animate corporations, but for now only biological humans can make decisions on their behalf and cause them to act.

Despite its academic and philosophical language, Vice Chancellor Laster explains that the question bears profound practical importance. If Delaware’s sovereign power transforms the corporation’s constitutive documents into a jural body, then the limitations on that sovereignty should still constrain entity. Poetically, he explains, Delaware’s authority through the power of a corporate charter should not be able to impose a forum selection clause on a federal securities claim (his ruling in Sciabacucchi v. Salzberg, 2018 WL 6719718 (Del. Ch. Dec. 19, 2018), which was reversed, 227 A.3d 102 (Del. 2020)) any more than it can legislate “north of the Twelve-Mile Circle.”

As a last point, I would submit that this conception of a corporation—a corpus of property, combined with a writing, thereby animated by the intervention of the sovereign power at the behest of natural persons who thereafter control the entity—does suggest an answer to the vice chancellor’s question. What the state has created, in this description, is a golem.

The opinion in NEA is sure to be an oft-cited watershed for its specific holdings, creating a test for the validity and enforceability of anti-suit covenants that frequently feature in instruments pertaining to private equity transactions. NEA’s practical holdings are, indeed, landmark. But, practitioners should not overlook the candid look the vice chancellor has given into his foundational understanding of corporate law.

Reprinted with permission from Delaware Business Court Insider, © ALM Media Properties LLC. All rights reserved.