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An Advantage to Incorporating in Delaware is Ratifying Defective Acts

By Sandra B. Feldman, Publications Attorney for CT Corporation.

What happens if a corporation issues more stock than authorized by its certificate of incorporation? Or declares that a director was elected, even though that person did not receive the vote required by the bylaws?  Those actions are void or voidable for noncompliance with the requirements set forth in the corporation statute and internal documents. This causes uncertainty and could lead to serious problems when looking for investors or during an acquisition.

Is there anything a corporation can do to validate those acts? In Delaware, the answer is “yes”. Last April, two innovative sections of the Delaware General Corporation Law (GCL) went into effect: GCL sections 204 and 205 allow a corporation to validate corporate acts that would otherwise be invalid due to a failure to comply with a provision of the GCL or a governing corporate document. Sec. 204 allows the corporation to validate the act. Sec. 205 allows the Delaware Chancery Court to do so. And recently, the Delaware Chancery Court published an opinion giving us some much-anticipated guidance on the new provisions.

Corporation Law Sec. 204—Validation By the Corporation

Sec. 204 provides a “safe harbor” procedure under which a corporation can ratify defective corporate acts or transactions.  That procedure requires the board of directors to adopt a resolution stating: 

  • The defective corporate act to be ratified,
  • The time of the defective corporate act,
  • If an issuance of shares is involved, the number and type of shares and the date issued, 
  • The nature of the defect,
  • That the board of directors approves the ratification of the defective corporate act.

Shareholders have to approve the resolution if a shareholder vote would have been required to authorize the defective act.  And if the act being ratified would have required a filing with the Delaware Secretary of State, the corporation is required to file a Certificate of Validation.

CT TipDelaware has filed about 150 Certificates of Validation so far.

Corporation Law Sec. 205—Validation By the Court

The other section, Sec. 205, authorizes the Delaware Chancery Court to ratify a corporate act or transaction not ratified by the corporation under Sec. 204.  Recently, the Delaware Chancery Court issued its first published opinion interpreting Sec. 205: In re Numoda Corporation Shareholders Litigation, C.A. No. 9163, decided January 30, 2015. 

The case involved a dispute over the capital structure of two Delaware corporations.  The board of directors had used informal processes to carry out its acts.  It purported to issue stock in several transactions without following the corporation law’s requirements.  A lawsuit was filed to determine: Who were the corporation’s rightful directors?   In that lawsuit, the Chancery Court ruled that the stock issuances were invalid.  The parties then brought an action under Sec. 205 to validate five stock issuances.

The Delaware Chancery Court explained that Sec. 205 allows the court to ratify acts where judicial intervention is preferable or, as in this case, necessary because they are not sure who the directors are.  The court then stated that the first step is for it to determine if there really was a corporate act.  If there was, then Sec. 205 gives the court discretion to decide whether to validate it.

CT TipThe court said that, for example, an agreement to take some action, made by two of three directors during an informal conversation, would not be a corporate act

Here, the court decided not to validate one stock issuance because there was no evidence to establish any board approval of the issuance and, therefore, there was no act to validate.  However, the court validated the remaining stock issuances where the evidence showed:

  • The parties operated for years assuming the capital structure based on those issuances was the actual capital structure, 
  • One of the shareholders could lose a significant voting interest if the court did not validate the issuance,
  • Validation would put the shareholders where they expected to be.

CT TipIn deciding whether to exercise its authority to validate a defective act the court may consider a number of factors including whether there was a belief the act was in compliance with law, whether the corporation and board treated the act as valid and whether there will be harm to anyone by ratification.

It is actually not that uncommon for a corporation to issue stock or take other actions without realizing that there are statutory formalities that must be followed.  And it can be years before the defects are discovered.  But once they are—say during due diligence for an acquisition, or when the corporation is looking for new investors—the consequences can be severe.  Secs. 204 and 205 provide a useful mechanism for corporations to avoid those consequences.

For assistance in filing Certificates of Validation or other Delaware documents contact CT.

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