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Del. Statute Gives Companies a Way To Clean Up Defective Corporate Acts

Monday, March 3, 2014

By Che Odom  

Feb. 14 --Imagine a company discovering ahead of a merger or public offering that it has overissued its stock. Previously, this would have been an incurable invalid corporate act.

A new law that takes effect April 1 in Delaware, however, may help corporate counsel clean the books of such defective acts.

Dean F. Hanley, partner and co-chair of the securities practice group at Foley Hoag LLP of Boston, told Bloomberg BNA Feb. 13 that Sections 204 and 205 of the Delaware General Corporation Law (DGCL) “will likely become the default mechanism that lawyers turn to when they discover apparently invalid corporate acts.”

Such invalid actions are typically found in startups and privately held companies, though even “well-established companies make mistakes, too, on occasion,” he said.

Sections 204 and 205, signed into law July 30, 2013, by Gov. Jack Markell, establishe a process for ratification of defective corporate acts by a corporation itself or through validation by the Delaware Court of Chancery.

Through these devices, the defective acts will be deemed retroactively effective and valid as of the time of the defective corporate act. This would make valid decisions, such as the election of directors, made by holders of putative stock.

The ratification provisions are designed to address issues that have “been around forever,” Hanley said.

“Not surprisingly, startup companies are often more worried about developing a product and paying the bills, than getting every legal nicety just right,” he said.

When corporate counsel finds a problem, he or she will attempt to ratify the doubtful acts by getting directors or shareholders to “bless them” with a formal resolution, but until now no recognized statutory procedure existed for ratifying defective acts, Hanley said.

In the past, everyone “agreed that an overissue of stock was basically void and incurable and had to be dealt with some other way, sometimes with adverse tax or other consequences,” Hanley said. “The new statute offers a solution to the overissue problem, which is very helpful.”

'Pent-Up' Need

Katherine R. Lofft, an attorney and member of Epstein Becker & Green PC, said she believes there is “pent-up interest” and need for a defined procedure that allows companies to “clean house” and set their corporate, governance or capital structure on a solid foundation, “whether in advance of an anticipated merger or IPO transaction or otherwise.”

“I think the significance of the legislation is in its clear intent to address a line of Delaware cases which held that certain so-called 'defective corporate acts' not only could be voided, but were void on their face and therefore not capable of remedy, even as a matter of equity,” she said.

Delaware courts have historically taken a conservative approach to matters of corporate process, requiring companies to strictly adhere to the DGCL, Lofft said.

In enacting Sections 204 and 205, the legislature may have felt that the courts had gone too far in finding certain deficiencies were not capable of remedy, she said.

“Notwithstanding the perspective of some Delaware judges, the reality is that it is not uncommon for new, emerging and/or small companies in particular to founder when it comes to strict compliance with the law,” she said.

The failure to comply with the requirements under the DGCL may be due to “entirely innocent” reasons, Lofft said.

For example, a company may have kept incomplete records such that it cannot confirm that it did satisfy the applicable law, or it may be transitioning attorneys, causing some procedural requirements to fall through the gaps, Lofft said.

“This development may enhance access to capital and help increase business transaction activity. It may help attract even more companies to organize (or re-organize) in Delaware, which is already the leading state for corporate formation,” she said.

Sections 204 and 205

To ratify a defective act under Section 204, the board must adopt a resolution ratifying the act or putative stock and providing certain disclosures.

If the act would have required stockholder approval to be implemented, then stockholders must also adopt the ratification resolution. In addition, the corporation must provide shareholders with 20-days notice of the meeting at which the resolution is to be adopted.

The notice must go to holders of valid stock and putative stock, whether voting or nonvoting, both current and at the time of the defective corporate act.

Once approved by the board and, if applicable, the shareholders, the corporation must file a “certificate of validation” with the Delaware Secretary of State.

If stockholder approval was not required, the corporation must provide notice of the ratification to shareholders within 60 days of adoption of the ratification resolution by the board.

Turning to Court

Corporations have another avenue if they do not want to undertake the ratification route.

Certain companies may petition the court of chancery to validate independently any defective corporate act or putative stock. Section 205 also gives the court authority to hear challenges to the validity and effectiveness of any ratification undertaken by a corporation under Section 204.

Hanley said he views the change in law as a positive development. The new statutes have “specific requirements, and it may not be possible to satisfy those requirements in a given case,” he said.

“Better to get it right the first time,” he added.

Companies should note that the “self-help” ratification procedures also take time to effect, Lofft said.

“Of course, there are failures or deficiencies that may not be susceptible to ratification via the 'self-help' process, such as a deficiency in the election of directors--after all, a board that is not duly elected under the law cannot vote to ratify its own defective election,” she said. “These matters would need to be addressed via appeal to the Delaware Court of Chancery,” under Section 205.

 

To contact the reporter on this story: Che Odom in Washington at codom@bna.com

To contact the editor responsible for this story: Kristyn Hyland at khyland@bna.com


The text of Sections 204 and 205 are available at http://delcode.delaware.gov/title8/c001/sc06/.

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