Overview and Key Practical Takeaways
An important but unresolved issue for private equity (PE) and venture capital (VC) in Canada is how fiduciary duties may be transferred from an investee company's directors to a shareholder by operation of a unanimous shareholder agreement (USA).1 While Canadian corporate law is clear this can occur,2 virtually no Canadian judicial guidance has been provided as to when and to what extent.3
This is an important issue. Where directors' duties are transferred to shareholders by operation of a USA, the shareholders also assume the associated liabilities. This can raise particularly complex issues for PE and VC investors in connection with the duty of loyalty given that they often hold interests in multiple portfolio companies operating in the same industry. PE and VC investors therefore desire clarity regarding when they might have assumed the duty of loyalty by operation of a USA, so they can be mindful of the duty when making decisions relevant to more than one portfolio company.
Given the uncertainty of Canadian corporate law on this critical point, the recent (and much discussed) ruling of the Court of Chancery in Moelis4 is noteworthy for its potentially significant impact. Although decided under Delaware law, the questions at issue offer guidance regarding how a Canadian court could approach the transfer of duties from directors to shareholders by operation of a USA. Below are key practical takeaways for PE and VC in Canada:
- The question under Canadian law is whether a USA's terms restrict the powers of the directors to manage the business of the company.5 Where such a restriction occurs, the directors' duties (and associated liabilities) transfer to the applicable shareholder(s).6
- Moelis suggests a mere shareholder approval right may be sufficient to effect such a transfer. Further, Moelis suggests it is irrelevant whether the right is drafted as a "pre-approval" right or as a "veto" right. Nor may it matter if the right is actually exercised: the mere existence of the right may be sufficient.
- For PE and VC investors in Canada, this issue will be most salient where the investor holds interests in other portfolio companies and a business issue subject to a shareholder right under a USA is relevant to more than one of the companies. In particular, the investor must be careful the issue is handled cognizant of the potential applicability of the duty of loyalty and the potential liability that could ensue if the duty is breached (e.g., by exercising the control right in a way that prioritizes the interests of another portfolio company over the best interests of the portfolio company governed by the USA).
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Moelis: Shareholder Approval Rights Impact Director Authority
Moelis examined the enforceability of certain approval rights in favour of the company's founder under a shareholder agreement pursuant to Delaware General Corporation Law (DGCL).
The plaintiff challenged the validity of the approval rights, arguing they conflicted with DGCL section 141(a), which states "the business and affairs of every Delaware corporation... shall be managed by or under the direction of a board of directors..."7 The question the Court faced was therefore whether the founder's approval rights infringed upon the directors' authority to "manage" or "direct" the "business affairs" of the company.
The Court ruled that they did. Citing "seminal" precedent, the Court explained that governance restrictions violate DGCL section 141(a) when they "have the effect of removing from directors in a very substantial way their duty to use their own best judgment on management matters" or "tend to limit in a substantial way the freedom of directors on matters of management policy..."8 The Court ruled that the founder's approval rights met this standard.
Critical here was that, consisting of "eighteen different categories of action," the approval rights "encompassed virtually everything the Board can do." Indeed, because of the breadth of the approval rights, the Court explained that the directors were effectively prevented from "exerciseing their own judgment." The Court elaborated:
Taken together, the approval rights force the Board to obtain the founder's prior written consent before taking virtually any meaningful action. With the approval rights in place, the Board is not really a board. The directors only manage the Company to the extent the founder gives them permission to do so.
...
The Board cannot approve, authorize, or even plan to take a covered action without the founder's prior written approval. The Board cannot freely exercise its powers; it must go to the founder first... The directors can only act freely when they do what the founder wants. Otherwise, they cannot act.
In addition, although the approval rights were drafted as "pre-approval" rights, the Court stated that "rewriting" them as "veto rights" would "not change anything." Specifically, even if "framed" as vetoes, the approval rights would still give the founder the "ability to block virtually anything the Board might do." This meant the board was "in the same position as a management team who proposes options for a board to review and approve." The fundamental point was therefore that "the power to review is the power to decide" such that the "business and affairs" of the company were being managed "under the direction of the founder, not the Board."
What Might Moelis Mean for PE and VC in Canada?
It is not uncommon for Canadian courts to consider Delaware law, especially when Delaware law is well developed in a particular area and Canadian law is not.9 Given the similarities between DGCL section 141(a) and Canadian statutory provisions such as CBCA section 146(5),10 Moelis appears to be a strong candidate for similar consideration in the future.
What, then, are the key practical takeaways from Moelis for PE and VC investors in Canada? We highlight the following:
- The test affirmed by the Court sets a relatively high standard for the authority of the company's directors to be infringed. Specifically, shareholder rights must "have the effect of removing from directors in a very substantial way their duty to use their own best judgment on management matters" or "tend to limit in a substantial way the freedom of directors on matters of management policy..."
- That said, the Court accepted this standard could be met by mere shareholder approval rights. Nor was the Court overly concerned with such technicalities as whether the approval rights were drafted as "pre-approval" rights or "veto" rights. Rather, the Court's primary concern was, given the approval rights, whether the board truly remained at liberty to "exercise its own judgment" and to "act freely."
- Similarly, the Court did not require that a shareholder approval right was actually exercised. The mere existence of the right was sufficient. The Court's rationale was that the practical impact of the right, whether drafted as "pre-approval" rights or "veto" rights, was that the directors would consult closely with the applicable shareholder(s) prior to seriously considering any action subject to the approval right.
- Moelis tackled the impact of the applicable approval rights collectively to find they violated DGCL section 141(a). By contrast, CBCA section 146(5), in its use of the phrase "to the extent", expressly contemplates a partial transfer. This clearly implies that a transfer of fiduciary duties from the directors to one or more shareholders under the CBCA (and similar Canadian corporate statute) could occur on a "right by right" basis.
- For PE and VC investors in Canada, the transfer of directors' duties to shareholders can raise sensitive situations, in particular, if an investor benefits from a control right relevant to conflicting interests between different portfolio companies. Here the investor should be careful the matter is navigated cognizant of the potential applicability of the duty of loyalty and the potential liability that could ensue if the duty is breached (e.g., by exercising the control right in a manner that favours the best interests of another portfolio company over the best interests of the portfolio company governed by the USA).
- Moreover, for VC investors specifically, the practice of including a long list of "protective provisions" should be considered in light of Moelis and the particularities of Canadian corporate law. And the issue becomes even more relevant where a lead investor has specific consent rights which may be in addition to the protective provisions in favour of the "preferred majority".
- Lastly, for U.S. investors into Canada, this possibility also requires appreciation of the distinct nature of fiduciary duties in Canada and the fact that Canadian law is clear the duties are owed to the company and not to any of the company's stakeholders, whether shareholders or otherwise. As such, should fiduciary duties wholly or partly be transferred to a shareholder by virtue of shareholder control rights, complying with those duties will entail a somewhat different analysis than under U.S. law.
Concluding Comments
While it remains to be seen whether a Canadian court will adopt all or part of the logic of Moelis, the case underscores the importance of understanding how shareholder rights interact with the authority of directors when negotiating and drafting USAs, and how one or more shareholder right can result in the transfer of directors' duties (and associated liabilities) to the applicable shareholder(s). Deliberate and targeted drafting may therefore be prudent.
Footnotes
1 In the context of venture capital financing, it is common practice for the parties to the standard shareholders agreements of the Canadian Venture Capital Association (notably the voting agreement, investors' rights agreement, and right of first refusal and co-sale agreement) to include language clarifying that together, those agreements do indeed form a USA. It is also fairly common for the parties to transfer the "protective provisions" (VC-speak for "veto rights") from the articles into the voting agreement, thereby contractually binding the transfer of directors duties to one or more preferred shareholders (most commonly a "preferred majority") via a USA.
2 See Canada Business Corporations Act, RSC 1985, c C-44 (CBCA) at s.146(5); Business Corporations Act, RSO 1990, c B.16 (OBCA) at s.108(5); Business Corporations Act, RSA 2000, c B-9 (ABCA) at s.146(7).
3 See Ontario Business Corporations Act & Commentary (LexisNexis, 2020) at page 36: "There are... a number of unresolved questions raised by insufficient statutory provisions, e.g., the degree to which liability, as well as responsibility, has been shifted to the shareholder."
4 West Palm Beach Firefighters' Pension Fund v. Moelis & Company, C.A. No. 2023-0309-JTL (Del. Ch. Feb. 23, 2024) Moelis. The ruling in Moelis, together with certain other recent decisions by the Delaware courts that were not well-received by market actors, ultimately lead to a series of amendments to the DGC in June 2024.
5 See, for example, CBCA s.146(5): "To the extent that a unanimous shareholder agreement restricts the powers of the directors to manage, or supervise the management of, the business and affairs of the corporation, parties to the unanimous shareholder agreement who are given that power to manage or supervise the management of the business and affairs of the corporation have all the rights, powers, duties and liabilities of a director of the corporation, whether they arise under this Act or otherwise, including any defences available to the directors, and the directors are relieved of their rights, powers, duties and liabilities, including their liabilities under section 119, to the same extent."
6 Note that the British Columbia Business Corporations Act, SBC 2002, c 57 (BCBCA) approaches the transfer of fiduciary duties from directors to shareholders differently than other Canadian corporate statutes, including that (i) the transfer must occur by operation of the corporation's articles rather than by a shareholder agreement per BCBCA s.137(1), and (ii) the articles must expressly address the intended transfer per BCBCA s.137(1.1)(b). For this reason, this article focuses on the CBCA, OBCA and ABCA, none of which include an equivalent to BCBCA s.137(1.1)(b).
7 Emphasis added. The full text of DGCL section 141(a) reads: "The 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. If any such provision is made in the certificate of incorporation, the powers and duties conferred or imposed upon the board of directors by this chapter shall be exercised or performed to such extent and by such person or persons as shall be provided in the certificate of incorporation."
8 Emphasis added, and quoting Abercrombie v. Davies, 123 A.2d 893, 899 (Del. Ch. 1956).
9 For a recent example, see Fairstone Financial Holdings Inc. v. Duo Bank of Canada, 2020 ONSC 7397 (CanLII) where the court relied far more heavily on Delaware precedent than Canadian precedent in deciding a "material adverse effect" dispute arising from an M&A transaction valued at over CA$1 billion.
10 Both are focused on the authority of a company's directors to steer the company. They also employ nearly identical key terms. DGCL section 141(1) uses the terms "manage," "direct" and "business affairs". CBCA section 146(5) uses the terms "manage," "supervise" and "business and affairs."
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
