In an order granting plaintiffs' motion for judgment on the pleadings in Schroeder v. Buhannic, C.A. No. 2017-0746-JTL, Order (Del. Ch. Jan. 10, 2018), Vice Chancellor J. Travis Laster held that a provision in a stockholders agreement that purported to limit the board's authority to select the company's chief executive officer was ineffective because it conflicted with the Delaware General Corporation Law.

Plaintiffs sought a declaratory judgment pursuant to Section 225 that a consent executed by the holders of a majority of the common stock of TradingScreen Inc., intending to make changes to the composition of the management and board of directors of the company, was ineffective in light of the company's governing documents, including the company's charter, bylaws and a stockholders agreement entered into by all of the company's preferred and common stockholders.

The consent professed to remove plaintiff Schroeder as the company's CEO and to appoint defendant Buhannic as CEO and chairman of the board. Section 7.2 of the stockholders agreement provided for a board of directors consisting of seven directors, to be selected as follows: two representatives designated by the holders of a majority of the Series D Preferred Stock, provided that each such director certified to the company that he does not serve as an officer or on the board of directors of any company that directly competes with the company; three representatives designated by the holders of a majority of the common stock, one of whom shall be the chief executive officer of the company; and two independent, nonemployee representatives nominated by the holders of a majority of the common stock, subject to the approval of the holders of a majority of the Series D Preferred Stock.

The parties disagreed about the meaning of the provision calling for the designation of three directors by the holders of a majority of the common stock. The plaintiffs argued that it required the common stockholders to fill one of their seats with the board-selected CEO. The defendants argued that the common stockholders were free to nominate whomever they pleased, and this provision actually restricted the board's ability to choose a CEO by limiting the pool of potential CEO candidates to one of the three directors appointed by the holders of the majority of the common stock.

Laster found that both interpretations of the provision were reasonable when considered in isolation. However, when the provision was read in the context of the other parts of Section 7.2, only the plaintiffs' interpretation was reasonable. Each clause in Section 7.2 identified the number of directors that a group of stockholders could appoint, then modified that authority with language limiting who the nominees could be. Thus, the nominees by the holders of the Series D Preferred Stock had to make the required certification regarding lack of service as an officer or director of a competing company, and the independent, nonemployee representatives nominated by the common stockholders had to be approved by the holders of a majority of the Series D Preferred stock. The provision regarding the nominees by the holders of a majority of the common stock required that one of the nominees be the CEO of the company. The defendants' reading of the provision would violate the parallel structure of Section 7.2 if it restricted who the board could appoint as the CEO rather than who one of the common stockholders' nominees could be. Moreover, the defendants' reading was inconsistent with the purpose of the section as a whole, which dealt with nominees for election to the board and not with the selection of the CEO.

The plaintiffs' reading of the provision was also the only reasonable interpretation in light of the company's other corporate documents. The company's bylaws authorized the board to select the CEO and stated that the CEO need not be a director. The defendants' reading would limit the board's choice of CEO to one of three candidates identified by a subset of the stockholders and require that the CEO already be a director. The plaintiffs' reading recognized that the board selects the CEO, who need not be a director at the time of the selection, but then that individual must be one of the common stockholders' nominees to serve as a director.

Finally, and most interestingly, Laster concluded that only the plaintiffs' interpretation was reasonable when read against the requirements of the Delaware General Corporation Law. Appointing the CEO is a core board function that can only be limited in the certificate of incorporation pursuant to Section 141(a) of the DGCL or the bylaws pursuant to Section 142(b) of the DGCL. In this case, the disputed provision appeared in the stockholders agreement. If it unambiguously attempted to limit the board's authority to select the CEO, it would be ineffective because it would conflict with the DGCL. If it were an attempt to limit the board's exercise of its authority over the business and affairs of the corporation in a manner not contemplated by statute, the provision would represent an impermissible delegation of the board's authority. Thus, when read against the backdrop of the DGCL, as well as in context, Section 7.2 of the stockholders agreement mandated that the common stockholders appoint and maintain the board-appointed CEO as a director, and did not confer on the common stockholders the power to appoint or, in this case, to remove the company's CEO. For this reason and other reasons discussed in the order, Laster held the consent to be ineffective and granted judgment on the pleadings in favor of the plaintiffs.

The order is significant because of Laster's reliance on the DGCL to interpret a stockholders agreement so it would not run afoul of the basic principle that the directors, rather than the stockholders, manage the business of the corporation, including the hiring, monitoring, and firing of the CEO. Although only one of several rationales for the court's decision, it is an important one that bears remembering when drafting stockholders agreements.

Barry M. Klayman is a member in the commercial litigation group and the bankruptcy, insolvency and restructuring practice group at Cozen O'Connor. He regularly appears in Chancery Court.

Mark E. Felger is co-chair of the bankruptcy, insolvency and restructuring practice group at the firm.