Founders of corporations frequently grant themselves preferential rights and powers in the corporate documents. However, if those preferences are contained in a shareholder’s agreement, some, if not all, may be unenforceable.

On February 23, 2024, the Delaware Court of Chancery (the “Chancery Court”) issued an opinion in West Palm Beach Firefighters’ Pension Fund v. Moelis & Co., invalidating commonplace stockholder agreement provisions that gave a significant stockholder certain consent and board appointment rights. It reviewed Section 141(a) of the Delaware General Corporate Law, which provides that the business and affairs of a Delaware corporation shall be managed under the direction of the board of directors. The Chancery Court struck down the entire package of stockholder veto rights and held that provisions in a stockholder agreement restricting the size of the board of directors, requiring the board to recommend in favor of a stockholder nominee, requiring the board to fill board vacancies with a stockholder nominee or requiring that the stockholder’s nominee serve on board committees are facially invalid.

While the Chancery Court’s analysis of Delaware corporate law is not directly applicable to California corporations, the import of the decision is that, under Delaware law, any rights in a stockholder agreement that remove or substantially limit the board’s duty to use its own best judgment on management matters or policy are facially invalid.

Although the Moelis decision may still be appealed and is not directly controlling on California corporations, there are similarities in the text of Delaware General Corporate Law section 141(a) and California’s analogous provision, section 300(a) of the California Corporations Code, which vests the power to manage the business and affairs of the California corporation in the corporation’s board of directors. Though Section 300(b) of the California Corporations Code expressly recognizes the validity of stockholder agreements to alter the conduct of the affairs of a corporation, it is only applicable to “close corporations.” The California Corporations Code does not contain a similar provision for other corporations.

Due to the similarities of the text, and unless and until §300(b) of the California Corporations Code is expanded to cover all California corporations, any provisions imposing restrictions on the internal governance arrangements of a California corporation should be included in the corporation’s articles of incorporation, as opposed to a shareholder agreement. This may also be accomplished, if permitted in the corporation’s articles, through the creation of a new class or series of stock with the restrictive rights established in a certificate of determination as opposed to a shareholder agreement.

If you are a founder and stockholder in a California corporation with preferential rights it is highly recommended that you contact your corporate lawyer to assure that the preferences are valid and recited in the proper documents.

The information presented is not intended to be, and does not constitute, “legal advice.” Because each situation varies, and only brief summary information is provided here, you should not use this information as a basis for action unless you have independently verified with your own counsel that it applies to your particular situation.